Inflation

Trading Basics

Inflation

Quick Summary: Inflation is the rate at which the level of prices for goods and services is increasing. Typically a country’s central bank will aim for inflation to be between 2-3%. When inflation increases too quickly, that country’s currency loses value on a global scale and goods within the country become more expensive for the population.

Full Overview:

What is Inflation?

Inflation refers to the rise in prices of goods and services. While a low inflation rate is considered healthy for an economy, problems arise when inflation starts to accelerate, which can cause severe economic problems. That’s why market participants closely follow the changes in the overall price level of goods and services and their rate of growth.

While inflation represents a rise in the overall level of prices, deflation refers to a decline in prices. Inflation and deflation are usually expressed as a percentage and indicate a decrease (or increase, respectively) in the purchasing power of a nation’s currency.

Many investors favour the implicit price deflator to measure inflation rates, which is released together with the Gross Domestic Product (GDP) report. However, that report is only published quarterly, and for a more timely inflation measure, market participants turn to the Consumer Price Index (CPI) and Producer Price Index (PPI). Those reports are released each month.

What Causes Inflation?

In essence, inflation can be classified into three types, depending on the cause: demand-pull inflation, cost-push inflation, and built-in inflation.

  • Demand-Pull Inflation

Demand-pull inflation forms when the demand for goods exceeds their supply. Higher demand, combined with lower supply, leads to an increase in the overall price level for a good or service and causes a rise in inflation. A typical example is oil: When oil-producing countries decide to cut production, thus lowering supply, this will usually lead to an increase in the price of oil if global demand remains the same.

Besides the supply-demand gap, demand-pull inflation can also occur with an increase in money supply, either by monetary authorities printing more money or devaluing the money currently in circulation. Both cases lead to increased demand, which in turn causes inflation rates to rise.

  • Cost-Push Inflation

Cost-push inflation occurs when the cost of production increases. For example, an increase in the price of raw materials used in the production of certain goods will eventually lead to an increase in the price of the final product, causing the overall price level in an economy to rise. Another example is rising labour costs and wages, which will also lead to an increase in the price of production process inputs.

  • Built-In Inflation

Built-in inflation occurs when workers demand higher salaries when overall inflation rates rise in order to maintain their cost of living. Higher wages can, in turn, lead to cost-push inflation, forming a wage-price spiral and increasing inflation even further.

Pros and Cons of Inflation

Depending on the perspective one takes, inflation can be either good or bad. A certain level of inflation is usually considered healthy for an economy (most major central banks target annual inflation of around 2%), as it promotes consumer spending and business investments. If there is no inflation in an economy, consumers might be unwilling to spend as the purchasing power of their savings would remain constant over time.

However, when things get out of control, both consumers and businesses may decide to postpone their spending/investments. High inflation or deflation may also lead to unemployment, imbalances in international trade, and can have a severe impact on a nation’s currency.

Inflation is usually considered good for individuals and businesses with tangible assets, such as real estate. In that case, inflation will cause a rise in the property’s value, allowing the owner to sell the property at a higher price in the future. On the contrary, buyers will have to pay a higher price as inflation erodes the value of their savings and/or causes interest rates to rise. Individuals and businesses with high savings don’t like inflation, as the purchasing power of their money decreases over time.

Examples of Hyperinflation

While there are many examples of failed monetary authority actions that led to extreme inflation (hyperinflation), a famous example is that of the German Weimar Republic in the early 1920s. After the end of World War I, the victorious nations demanded high reparation costs from Germany, which already had a weak economy struck by the war. In order to repay its debts, Germany decided to print enormous amounts of paper money which led to a rapid devaluation of the German mark and hyperinflation.

As a result, German consumers tried to spend their savings as fast as possible, expecting that their money would become worthless with the rapid increases in overall price levels. This caused an even higher supply of money in the economy, increasing inflation even further.

Types of Inflation Reports

As noted earlier, market participants follow the Consumer Price Index (CPI) and Producer Price Index (PPI) to get a timely measure of inflation pressures in the economy. Both the CPI and PPI reports are calculated and published by the US Bureau of Labor Statistics (BLS).

The reports are released around the middle of the month, covering data from the previous month. The PPI report is usually released one business day before the CPI, providing market participants with an advance insight into how the CPI numbers may look like.

Consumer Price Index

The Consumer Price Index (CPI) tracks the changes in prices of a weighted basket of a few hundred goods and services at the consumer level. The basket consists of typical household expenses, including food, education, and entertainment, to name a few.

To gather the data used for the calculation of the index, the authority that publishes the report visits supermarkets, gasoline stations, department stores, and other establishments to get an accurate reading of the current price levels. Housing costs account for the largest share of the CPI index, followed by consumption, and food & beverages.

The base year of the CPI index is 1984, meaning that a CPI index of 145 reflects an increase of 45% in the price level of goods and services over the base year.

Since energy and food prices tend to be quite volatile, economists have developed the Core CPI which excludes the highly-volatile categories of energy and food. The Core CPI index provides a better view of long-term inflationary trends in an economy.

Producer Price Index

The Producer Price Index (PPI) tracks the changes in the selling prices of goods at various stages of production. Components of the PPI are weighted according to their share in a country’s GDP, and for the US PPI report, the base year is the same as for the CPI report – 1984.

The PPI report provides a different perspective at the current inflationary pressures than the CPI report. The PPI measures the change in production costs of goods, including raw materials and intermediate goods. Looking at the PPI data, traders can get a feeling of how fast inflation is travelling in the manufacturing process and when they could appear at the consumer level, creating cost-push inflation.

Since the PPI report is released one business day before the CPI report, some traders try to anticipate the actual CPI number by looking at PPI. However, both reports are quite different in their composition and calculation: Unlike the PPI report, the CPI report also includes changes in the price-levels of services, which account for the largest share of developed market economies. The PPI report, on the other hand, includes changes in prices of raw materials, which can be very volatile on a monthly basis.

Expert Tip: Never use the PPI report as an indicator for the upcoming CPI report. Those reports are very different in their construction.

How to Trade Inflation?

In order to trade the inflation rate report, traders need to understand what effect a falling or rising inflation rate has on the exchange rate of a currency.

In general, a positive inflation rate is considered healthy for the economy and bullish for the nation’s currency until the inflation rate gets out of control. In most cases, the inflation rate targeted by major central banks around the world is around 2% per year, which means that any rising inflation rate that is heading towards the central bank target is usually bullish for the currency.

For example

If the US records a rise in the CPI from 1.2% to 1.4%, the US dollar will usually experience increased demand and a rise in value. On the other hand, if the inflation rate rises from 2.5% to 3.0%, that will usually have a negative impact on the currency’s value.

On February 14, 2018, the United Released the monthly CPI report which came in at 0.5%. Market expectations were set at 0.3%, while in the previous month the monthly CPI increased only by 0.1%. The market interpreted those numbers as an increasing inflation heading towards the Fed inflation rate target. Rising inflation will eventually lead to an increase in interest rates in order to control inflationary pressures and cool down the economy.

The following chart shows the response of the US dollar. Immediately after the release, the currency rose to a fresh multi-day high, forming an extremely bullish candlestick. The US dollar index shown on the chart represents the value of the US dollar compared with a basket of major currencies.

A chart showing how the CPI report affects the US dollar

If you’re following a news trading strategy, trading the CPI and PPI reports is pretty much the same as trading any other market report. The “straddle” strategy implies placing a buy stop order just above the current exchange rate and a sell stop order just below the exchange rate a few minutes before the release. Since we know that the markets will be volatile, but aren’t sure about the direction, the pending orders will catch any move to the upside or downside caused by the market release.

A disadvantage of the “straddle” strategy is that both pending orders could be triggered if placed too close to the current exchange rate, creating a loss in one position and offsetting any profits created in the second position.

To avoid this situation, you can wait for a pullback after the report is released. Exchange rates have a tendency to return to the news pivot (i.e. price-level where a currency pair traded immediately before the release), offering you a nice trading opportunity to enter in the direction of the initial market reaction. However, unexpected market reports can often create strong buying or selling pressure where the price never returns to the news pivot.

Expert Tip: Mark the news pivot before the release with a horizontal line.

Hedging Against Inflation

In times of relatively high inflation, the worst decision would be to stick to your savings account and see the purchasing power of your money vanish. To hedge against inflation and take advantage of it, the stock market is usually considered the first choice by many market participants. Rising prices in the production cost, labour cost, or transport usually leads to an increase in the price of the final product, eventually increasing the company’s profit and the price of its stocks.

Alternatively, investors can invest in low-risk government bonds that are indexed to inflation rates. Those Treasury Inflation-Protected Securities (TIPS) increase the principal amount invested by the current percentage of inflation.

Gold can also be considered as a hedge against rising inflation, especially if the inflation is caused by increased money supply and loose monetary policy. In those times, gold is the ultimate store of value.

Key Takeaways

  • Inflation refers to the rise in the overall price level of goods and services.
  • While a low inflation rate is usually considered healthy, hyperinflation can have a disastrous effect on the economy.
  • In times of positive inflation, owners of tangible assets will see the value of their properties increase, while individuals with a high level of savings will experience a fall in the purchasing power of their money.
  • The most timely measures of inflation are the monthly CPI and PPI releases.
  • The CPI measures the price-change in goods and services at the consumer level.
  • The PPI tracks changes in prices in intermediary goods uses in the production process.
  • Investors who want to hedge against inflation can do so by purchasing Treasury Inflation-Protected Securities (TIPS) or investing in equities. Gold is also considered a good hedge against extremely high inflation rates.

 Final Words

Whether you’re a trader, investor, or market analyst, it’s extremely important to understand the concept of inflation and its effect on the economy. The CPI and PPI numbers are released each month and provide an accurate and timely measure of general inflationary pressures.

Although the PPI report is released one day earlier than the CPI report, bear in mind that both reports use a different calculation method and track different baskets of goods and services. Therefore, avoid using the PPI report as an indicator of the upcoming CPI report.

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