Inflation can de-value a currency quickly when price rises for consumer products make the units of a country’s currency less valuable. Keeping inflation levels in check is the job of central bankers. Learn more about what causes it.
How Inflation affects financial markets
The level of inflation is one of the most important factors determining a currency’s strength. This is because inflation has a direct impact on central bank monetary policy.
Increasing inflation will push the central bank to consider tightening monetary policy by increasing interest rates. This is because:
- Too little inflation runs the risk of an economy falling into deflation.
- Too much inflation erodes the real value of money in the economy.
A central bank will aim to use monetary policy to regulate inflation at low and steady levels, often as its primary mandate.
INFOBOX: Inflation, Disinflation and Deflation
- INFLATION – is a general increase in the price level from one period to the next, usually, measure on an annual basis.
- DISINFLATION – This is where there is inflation in the economy, but the level of inflation is falling. The general level of prices is still rising from one period to the next but at a lower rate. For example, an economy that has a trend of inflation that has previously been at 2.0% then falls to 1.5% and then subsequently to 1.0% is experiencing a period of falling inflation, or disinflation.
- DEFLATION – This is where inflation has gone negative. The general level of prices has fallen from one period to the next. This is considered to be bad for the economy. The concern is that consumers accept that deflation is taking hold, which drives spending lower in the belief that prices of goods will be lower in the future.
Why is inflation so important?
Central banks look at inflation and use it as a primary gauge as to how to implement monetary policy. A central bank that sees inflation rising will be mindful that it may need to raise interest rates to keep control on prices. An increase in interest rates will make it more expensive to borrow and will subsequently choke off demand in the economy. The decrease in demand will then begin to put downward pressure on general price levels and moderate inflation again.
Inflation can, therefore, have a direct impact on monetary policy. For example, the US Federal Reserve (the Fed) has a “dual mandate” enacted into law by the Federal Reserve Act of 1977.
One part of the dual mandate is to promote price stability, and the other part is concerned with keeping unemployment low. The Fed has subsequently set a 2% inflation target that it is mandated to work towards. The Bank of England also has a 2% target for the Consumer Prices Index, while the European Central Bank’s mandate is for an inflation rate “below but close to 2%”.