Inflation and deflationThe 2 extremes every central bank fights.
Central banks have one main job: stable prices. Inflation and deflation are the 2 ways that job can fail, and every inflation number hints at what the central bank, and so the market, will do next.
When money buys less
Inflation means that prices rise and each unit of money buys less. The word comes from the Latin inflatio, a swelling. It has 2 main causes. The first is that goods themselves get more expensive. The second is that there is too much money compared with the goods and services available, so each unit of money is worth less.
Both causes tie inflation to the rest of this module. Oil and other raw materials feed into the price of almost everything, so when they rise, inflation follows, most of all in Europe, which imports much of its oil. A weak currency makes imports dearer and pushes inflation up, while a strong one makes them cheaper and holds it down. And when a central bank creates money, the second cause is at work.
Why falling prices are dangerous
Deflation is the opposite: prices fall. At first that sounds like good news, because your money buys more every month. For an economy it is poison. If everything will be cheaper next month, it pays to wait, so people put off buying, and businesses do the same with their investments.
Debt makes it worse. When prices fall, the real weight of a loan grows, because the money you owe is worth more and more. So households and companies avoid borrowing. Demand drops, company earnings drop and, in extreme cases, bankruptcies and a deep economic slump follow.
About 2% counts as stable
Because both extremes hurt, central banks aim for a middle ground: a small, steady rise in prices that keeps a safety margin above deflation, which is much harder to escape. Prices count as stable when inflation stays close to a set level, and both the European Central Bank and the US Federal Reserve aim for about 2% a year. Well above that, or below zero, the central bank steps in.
The eurozone shows both sides. In 2008, inflation briefly rose above 3%. Between 2009 and early 2015 there were spells of deflation, when prices actually fell. Each time the ECB had to act, because price stability is its main task.
Central banks are also largely independent. In nearly all Western countries the government cannot tell the central bank what to do with interest rates or the money supply, and can only influence it indirectly.
What an inflation number tells you
For a trader, inflation data is the starting point, because it tells you what the central bank is likely to do next. If inflation runs hot, expect a tighter, more hawkish central bank: talk of rate hikes and less money. If prices are falling, or inflation is stuck well below target, expect it to loosen with cuts or bond buying.
The currency follows that expected path. A hot number that makes a hike more likely tends to support the currency, and a soft one tends to weigh on it, for reasons the next lesson on the key interest rate explains. What counts is the number against the forecast, and what it changes about the next decision.
Watch inflation, because it tells you what the central bank will do, and the central bank moves the market.
On inflation release day
Check the forecast in the Economic Calendar. A reading of 3% when 3.4% was expected can weaken the currency, even though 3% is well above target.
Open Interest Rate Probability and see whether the odds of a hike or a cut moved. If they did, the number mattered. If they barely changed, the market had already expected it.
In short
- Inflation means money buys less, either because goods get dearer or because there is too much money for the goods available.
- Deflation feeds on itself: people wait to buy, firms hold back, debts weigh more and demand keeps falling.
- Central banks aim for about 2%, so every inflation number hints at their next move, and the currency follows that expected path.
Key terms
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.
- Deflation
- Falling prices across the economy. People delay spending because things get cheaper, which can push the economy into a downward spiral.
- Central bank
- The institution that sets a country’s key interest rate and controls the money supply, like the Fed, the ECB or the Bank of England.
- Hawkish and dovish
- Hawkish: a central bank leans towards higher rates to fight inflation. Dovish: it leans towards lower rates to support growth.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.