Trading News for Beginners – What is Inflation?

April 18, 2022 12:14

Inflation is another way to say the rate of increase in the prices of goods and services paid by consumers and businesses.  

It’s the opposite of deflation, which is the rate of decrease in the prices of goods and services.  

Newcomers to trading will soon see that the term inflation rate is used daily in the financial media and that it can have a massive market-moving impact on a range of asset prices and financial instruments.  

Rising inflation means higher prices for the average household because corporations pass on the cost of raw materials.  

Example of inflation 

An example of this would be construction materials. If you’re building a new house during a period of high inflation in crude oil prices, the cost of transporting cement and other building materials would be much higher than during a period of low or normal inflation. That’s because construction material producers decide to price in the higher costs and pass them onto consumers.  

Another factor is demand and supply. We often see sudden inflation in prices when demand is high and supply is short.  

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How important is inflation in Forex trading and Stock investing? 

Inflation rates are important and count heavily in the decisions taken by active Forex traders and stock investors. Inflation becomes real-time trading news when benchmark reports like Consumer Price Index (CPI) hit the headlines. Consumer price benchmarks track the prices of a basket of goods, including food and fuel.  

Consumer price reports 

Developed and emerging economies report CPI benchmarks every month as well as quarterly, half-yearly and annually. Beginners don’t have to be concerned that these reports come at random times or unexpectedly. The reports are included in Admirals Forex calendar and are a scheduled, standard and time-proven way to understand the direction of inflation.   

Understanding inflation is the first step to understanding how currencies are managed by central banks. If a central bank isn’t careful, high inflation can devalue a currency and undermine consumer spending power, leading to a recession or depression. 

Central banks realized that if they simply printed more money to combat high prices, inflation would spread into the currency itself and consumers would need more and more money to buy simple everyday goods.  

During periods of hyperinflation, the currency would then rapidly lose value compared to other currencies. Hyperinflation was seen in Germany during the Weimar Republic in the early 1920s when a loaf of bread cost millions of Marks to buy because the central bank printed too much money, making it nearly worthless.  

Higher interest rates control inflation 

Instead of printing more money so that consumers can buy more goods at higher prices, central banks now realise that it is best to limit monetary supply by raising interest rates in the banking system.

Monetary supply means the amount of cash, credit, loans and other types of liquidity available in an economy.  When inflation heats up past the target rate of two percent, the first thing a central bank does is to limit the amount of money distributed into an economy. 

In this way, loans become more expensive and consumers have to be more careful of how they spend and what they spend it on. The central bank tries to control the level of demand for goods and services, hopefully reducing inflation.  

Connecting the dots between inflation and asset prices 

The important thing for new traders is to start observing and connecting inflation rate news with price movements in financial instruments and their underlying assets. 

Which financial instruments are influenced by inflation rates? 

The Forex market is the biggest in the world and worth 2.4 quadrillion USD. The Contract for Difference (CFD) is the most-used financial instrument to trade underlying currency assets. 

How does this work in practice? Let’s take a scenario in which the Bank of England (BoE) sees inflation at the level of five percent. The central bank’s current interest rate guidance for the banking sector is 0.25 percent. In order to reduce the inflation rate back towards the target of two percent, the BoE hikes its interest rate guidance to 0.75 percent.  

Banks follow the guidance by raising their borrowing rates and because loans are more expensive, consumers borrow less and restrict their spending on goods and services. Consumers would likely put their money in savings accounts because deposit rates become more attractive with higher interest rates.  

All of these reactions to the inflation rate impact on the Great British Pound (GBP). 

The currency strengthens because investors and currency traders grow more confident that the central bank is controlling inflation and the GBP attracts buyers as a result.  

Interest rates on loans and deposits are now higher in the UK because of the BoE’s actions to control inflation and GBP-denominated assets like bonds and savings accounts gain value to investors.  

CFDs on currencies are traded in pairs, so the GBP’s relative value against another currency would strengthen in this scenario.  

To summarise, every trader and investor would benefit by understanding and observing the connections between inflation rate readings, central bank reactions and underlying asset price movements.  

Learn more about trading CFDs with Admirals in Forex 101. 

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks. 

Sarah Fenwick
Sarah Fenwick Financial Writer, Admirals London

Sarah Fenwick's background is in journalism and mass communications. She has worked as a correspondent covering Swiss Stock Exchange news and written about finance and economics for 15 years.