Inflation. Everything you Need to Know About it.

What is its role in the economy and our daily lives? How does it impact asset prices?

The first question that pops into our heads when we hear the word inflation is: Is it good or bad? And the answer will always be both yes and no. But before that, we should understand what it is, what causes it, and how is it stimulated or controlled?

We can categorize it in two ways, the first way is the main categorization (i.e. type) and the second way is how fast or which way it goes (i.e. magnitude and direction). We can start with the first categorization that gives us two main types of inflation:

  • Cost-push inflation: it occurs when the economy starts to overheat due to excessive growth activity. It can be explained by a simple imbalance in demand/supply powers where demand increases at a faster rate than supply. This type is usually controlled through a hike in interest rates and a decrease in money supply. Raising interest rates discourages borrowing for businesses and thus slows down the economy. Another effect of this is that it makes the currency more attractive as an investment and thus it appreciates in value. An appreciating currency has a deflationary effect.
  • Demand-pull inflation: it occurs when there is a general hike in global commodity prices or taxes. It is determined by the supply side. Intuitively, when commodity (raw materials) prices rise, the firms’ costs rise as well, and to combat this, they have to raise prices in order to keep their margins. An example of demand-pull inflation can be a gradual significant rise in oil prices. It is worth mentioning that this type of inflation is not desired as it is accompanied by a fall in the standards of living and due to the fact that governments cannot do much about it.

Now, we can categorize inflation according to how fast it moves or in which direction:

  • Regular inflation: This is the usual 2–3% expected annual rise in prices. It is the desired and targeted inflation level for many developed world countries as it can be controlled and does not hinder business and economic growth by much.
  • Disinflation: This is a fall in the rate at which inflation increases. For example, if inflation rose by 1% last year, a disinflation happens when inflation rises by 0.5% this year. It can be a warning signal that we are approaching a risky deflationary zone.
  • Stagflation: This is a relatively rare type where inflation is high and increasing while the economy is stagnating, and unemployment is high. The term was first used by the former Chancellor of the Exchequer Iain Macleod. This type of inflation can be considered the ultimate nightmare to central bankers as they do not really have much to combat it.
  • Deflation: Although it may seem like a good thing given that deflation is the general fall in prices, it has its repercussions over the long-term. When prices fall and consumers are happy in the short-term, businesses may suffer from decreased margins and may resort to lay-offs to survive.

More types of inflation:

  • Shrinkflation: This phenomenon occurs when prices stay the same, but firms reduce the size of their goods. Hence, it is another form of a price increase. Imagine 100 grams of a good priced at $1 in the form of a specific size bag. Shrinkflation occurs when the firm keeps the good at $1 with probably the same bag but usually fills it with 70–80 grams of the good. Therefore, the consumer sees the same product but in reality, there is less of it, thus, paying the same price for less.
  • Hyperinflation: It is a rapid uncontrollable rise in inflation. Usually happens in times of war and turmoil and not necessarily in developing countries. It has occurred in Germany and Russia before. There is not an exact percentage increase per year to signify inflation, but some people consider a 50% per month can be considered hyperinflation. The most notable of example is Zimbabwe in 2008 when the inflation rate reached 79,600,000,000% per month (That is 79 Billion percent).

More on financial crises in this article I have written recently:

Inflation has its effect on Asset Prices.

For a trader or an investor or even simply an average citizen, knowing the effect of inflation on wealth is important. We can summarize these effects below:

  • Equities: If inflation is around expectations, equities should perform positively. During high inflationary periods, equities do not perform so well and are generally negative. And finally, in a deflationary environment, equities are also negative due to the decline of the economic activity.
  • Fixed-income: A higher inflation is typically negative for fixed-income securities. As inflation can spur a rate hike, bond prices have to fall (Remember the negative relationship between bond prices and their yields). Fixed-income bonds are the most exposed to inflationary risk. If an investor has a bond that promises 3% a year when inflation is at 4%, the net gain is -1%. Return should be on a real basis (With inflation accounted for) rather than on a nominal basis (Without inflation). During normal times, the returns are relatively stable for both short and long-term fixed-income securities. When inflation is higher than expected, bonds perform poorly as prices drop due to rising yields. With deflation, bonds perform positively due to the fact that future fixed cash flows have a bigger purchasing power.
  • Commodities: Although the relationship between inflation and commodities is becoming more and more complicated over time, it is generally thought of as positive and many commodities can be seen as an inflation hedge (e.g. Gold).
  • Currencies: A slowly rising inflation can have a negative effect on currencies up to the point where investors expect a rate hike, then the effect becomes positive because the currency will be more attractive if it pays a higher yield.
  • Real Estate: If inflation is around expectations, real estate doesn’t move much and remains relatively the same. If inflation is above expectations or high, then it has a general positive effect as real estate values go up with inflation. During deflationary periods, it is a negative impact as prices start declining.

Inflation and the Business Cycle

The business cycle is a swing from expansion to contraction that follows the natural order of life. Sometimes, the economy is booming, others, it is suffering. If we hop on the cycle and start with the early upswing of the economy where the government policy is more or less stimulative (in order to provoke more growth), we find that inflation is still low but growth is rising. This is generally accompanied by a rising stock market as it depends on future expectations. Next cycle is what we call the late upswing with the policy becoming more restrictive as inflation starts increasing. The stock market is typically more volatile at this point and a little toppish (The word is derived from top). Then, the slowdown begins as we start to see the fruits of the restrictive policy, with inflation that continues to accelerate, growth goes down, and stock prices decline. At this point, bond prices start to go up as a means to search for safe assets. After the slowdown, we reach the recession mode which is characterized by a real slowdown in economic activity with inflation peaking. The stock market continues to decline until the late part of the recession where it picks up some steam. The government policy is loose during this period.

Stimulating and Controlling Inflation

Central banks have tools to stimulate or to control inflation. They can be either monetary or fiscal. Controlling inflation is mainly done through interest rates and money supply. The idea is that when an economy is doing well, it is bound to have inflation due to demand increasing at a possibly faster rate than supply. When this happens, prices rise to accommodate demand and if wages do not rise accordingly, it can be a problem. To combat this, central banks may decrease money supply through raising interest rates. When interest rates go up, businesses are discouraged from borrowing and continuing to expand and invest. This in turn has a deflationary effect and the aggregate result is that firms will decide not to invest now which will cool down the economy and lower the inflation rate. This deflationary effect coupled with attractive interest rates has the effect of increasing the currency’s value relative to foreign currencies.

A word on Quantitative Easing is a must in this section. It is a relatively new monetary tool where the central bank buys long-term securities in the open market in order to flood it with money thus increasing money supply and encouraging lending and growth. This also has the job of lowering rates. The latest quantitative easing started in March 2020 in response to the Covid-19 pandemic. Central banks can also sell securities in the open market in order to decrease liquidity and the money supply thus tightening up the monetary system.

Measuring Inflation

As inflation in its pure form is difficult to measure, many indicators exist to be a proxy for inflation. The most known one is the Consumer Price Index — CPI. The index is simply a weighted measure of the change in the prices of a basket of goods such as housing, medical care, education, and food. The formula used is very simple, but the work done to find the values is tedious.

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A rising CPI measure can be seen as an inflationary measure for the country and a sign of a falling currency. It can also be seen as an imminent sign of a rate hike which can paradoxically cause the currency to rise up in value due to investors’ expectations of the interest rate move.

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US CPI Year-on-Year Change.

The Misery Index

Created by Arthur Okun, the index is simply the sum of the annual inflation rate and the unemployment rate. It is used to measure how well the citizens are doing as the idea behind it is that a high unemployment rate and a high inflation rate burdens the standard of living of the average citizen.

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The US Misery index since 2001. Source: Bloomberg.
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The UK Misery index since 2008. Source: Bloomberg.

According to data from the official Misery Index website, the president with the lowest (best) change in the index was Harry Truman (1948–1952) finishing at -10.18. The president with the highest (worst) change in the index was Richard Nixon (1969–1974) finishing at a whopping +9.21. It is worth mentioning that Barack Obama (2009–2016) had a -1.06 change while Donald Trump (2016– until June 2020) is around +4.45.

Written by

Institutional FOREX Strategist | Trader | Data Science Enthusiast. Author of the Book of Back-tests: https://www.amazon.com/dp/B089CWQWF8

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