What Causes Inflation and where does the Money (really) go?

...because your savings being eroded away by inflation is just not cool!

6 minute read

Getting to grips with the relatively complicated topic of inflation is essential for your trading repertoire; the main reason being that it plays a fundamental role in the value of a country’s currency. It’s important to understand what inflation is; inflation is quite simply the rise in cost of products and services within an economy. This includes the cost of housing, travel, energy, clothing and gas. Governments measure the rate of inflation using the Consumer Price Index (CPI), this is a monthly statistic which is produced by a weighted average of a predetermined basket of goods - including gas, food, clothing, household maintenance, and also Online products (think computer games, toasted sandwich makers and heavy duty staplers - an essential part of any household's list of inanimate items that get used once in an Azure moon).

What Causes Inflation
Gas prices at the pump bear considerable weight in the monthly published Consumer Price Index, and can be a strong indication of rising inflation rates. This is especially true when oil prices are stuck in a trading range or even trending downwards.

Certain items are given more weight in the overall CPI, since governments are aware that a consumer will spend considerably more money on gas than they will on milk (as they should, remember, #if it's not your mom, it's not your milk!). The Consumer Price Index serves as an overall guide as to the cost of living, and therefore can be used to accurately identify both inflation and deflation.


It’s next important to understand what causes inflation to occur within an economy, and a sound starting point is to become familiarized with demand pull inflation. This is something which occurs when there is an increase in the amount of money circulating within an economy, and the premise runs along the lines that; more money chasing the same amount of goods and services will cause prices of those goods and services to rise. This happens because the increase in spending power increases demand, which in-turn raises price levels.


There are a number of reasons as to why there would be an increase in the amount of money circulating within an economy but the most significant factor is interest rates, when interest rates are low, more individuals are likely to borrow (what I mean is that more sheeple are primed to becoming debt slaves for ever and all eternity), and this leads to greater (fake) purchasing power. Another reason why there might be more money in circulation is due to high employment statistics, and it can be safely assumed that high employment figures will result in a population having more spending power (very basic stuff here).


The second factor which can cause inflation to occur is known as cost push inflation. This arises when a businesses costs to produce the goods or services it sells increase so much that they have to charge a higher price to consumers. Higher business costs can come about because of factors such as higher raw material costs, higher wage costs, higher taxes, a decrease in productivity, or higher importation costs. The higher price tag for consumers means they are now getting less value for their money and are being subject to inflation.


Another sector to be aware of is house prices, because whilst they don’t directly cause inflation, if they are rising substantially enough (which they have been over the past two decades), they can increase consumer spending power as individuals are able to borrow more against the value of their property. This in-turn can cause demand pull inflation and prices for products and services to increase.


Quantitative easing is yet another way in which additional money can be pushed into the economy, usually in an attempt to stimulate consumer spending. This doesn’t always have the desired outcome, especially if the economy is experiencing a recession. Under those conditions, consumers may be motivated to save, regardless if there is more cash available for them to spend.

"It's clear that inflation is simply a natural part of a healthy economy that is experiencing growth. Which is fine... unless you are Greta Thunberg."

Furthermore, inflation is generally good for a Government since it erodes away considerable chunks of debt which they owe to the Federal Reserve or Central Banks. If they owe $100 and inflation is running at 5%, then in 10 years time their debt balance sheet will have halved. A little inflation is also good for businesses; if a customer wants to purchase a dishwasher, and they know in a years time it will be 3% more expensive, it encourages them to "buy it now" (eBayers rejoice!). This results in an active and buoyant economy where businesses are selling and consumers are purchasing.


Whilst in principle, it is good for an economy to have a little inflation, if it gets too high consumers won’t be able to afford the high prices and the economy will nosedive harder than 737 MAX, possibly into recession if the affordability is too great. In an attempt to prevent this kind of scenario, and if a government feels the inflation rate is getting too high, they will raise interest rates. By raising rates they decrease the supply of money in circulation, forcing businesses to cut costs and in-turn lower the price of their goods and services; this is designed to have a cooling effect on hot inflation numbers.


It takes considerable skill and foresight to run an economy in this fashion, and Governments are continuously attempting to predict where inflation is headed so that they can raise the interest rates on the same curve. This approach gives them the ability to cut interest rates if and when a recession hits, and re-stimulate the economy back into growth. This is considerably more challenging post the ZIRP (zero rate interest policies) that governments used to re-stimulate the economy after the 2008 Global Financial Crisis, as when inflation gets hot and a future recession looms, there will be no ammo in the tank (as interest rates will have nowhere to go). Hyper-inflation will set in and there will be riots on the streets because it’s $200 for a loaf of bread (...I’d prefer a zombie apocalypse personally, but that’s probably wishful thinking).


As a professional trader you need to take a keen interest in a range of countries’ current inflation and interest rates, as well as the curve in which they are on. Acquiring this knowledge will not only give you an insightful addition to paint into your overall macro picture, but will also give you conviction and confidence when you trade a currency in the foreign exchange markets.


Enjoy this read..?
If you learned something that will genuinely help your trading, then please make a small contribution to show your appreciation and help the site improve and grow into something even better.
Show Support >