Inflation is the sustained rise in prices in an economy over a period.
Say, you had stuffed a $1 bill somewhere when you were a child and accidentally you come across it now. Can you buy what you desired at that young age now with the same $1 bill? Of course, it’s not possible since the prices are not the same, then and now. It is nothing but inflation.
And the same context can be interpreted in two ways.
One, it is the depletion in purchasing power of the currency.
Two, the increase in the price of the commodities.
Sometimes, it can be a combination of both.
The rate at which inflation rises is the inflation rate. It varies year on year and differs from country to country.
In developed countries, the rates are low, whereas in emerging economies it is way higher. And so, developed economies strive to thrive their rates while the emerging economies try to pare it down.
So, is inflation good or bad?
A commoner needs a wage rise every year.
Entities need to post gains year on year.
And statespersons love to add job numbers to their tally to increase their approval rating.
Be it needy or creamy; all want one thing in their life — growth. And the need is perpetual. But the irony is nobody wants to pay a higher price. So the incumbents of monetary and fiscal policy create an illusion — prices staying steady. However, in reality, they allow prices to notch up sporadically, keeping the laymen oblivious. It ensures a profit for businesses and they give it back to society in three ways.
#1 Wage rise, which gives purchasing power to the people and nullifies the effect of price rise.
#2 Expansion, which creates more jobs in the society.
#3 Higher tax collection, which leads to increased government spending on welfare measures.
So, it is a win-win situation for every participant in the economy.
However, if the rate soars beyond the growth rate (GDP) of the economy, then it leads to hyperinflation. It does more harm than good.
Harm#1 Value of savings takes a hit. The spread between the interest rate and inflation rate widens during hyperinflation.
Since the remuneration for savings is unappealing, people tend to spend more than save.
Harm#2 Investor confidence caves in for two reasons. One, the inward remittance in the hedge and mutual fund plummets owing to extra spending. Second, entities cannot cope up with the rising demand for investment. So, they punctuate the expansion and tend to cut down costs by paring the headcount.
So, neither deflation (decrease in prices) nor hyperinflation is favorable to an economy. The gradual price increase, which is inflation, only befits and benefits the economy.
How does inflation affect the currency exchange rate?
Although inflation does not have a direct say in the exchange rate, it finds its way through the interest rate.
They both are a twin duo. Wherever one goes, the other follows.
Case#1: When the inflation rate soar
It indicates a superhot economy. If the central bank feels hyperinflation is a probability, then it raises the interest rate. As a result, investors embrace the high yielding asset for the currency carry trade — buying and holding the currency for the overnight interest gain. Also, the FIIs park their funds in high yielding fixed income securities, such as bonds, to leverage higher rates. These factors lead to a surge in the exchange rate. At times, investors load their bags in advance, pre-empting an interest rate hike, which creates demand as well.
Case#2: When the inflation rate is down and under
It envisages a slowdown in the economy. And the central banks cut the rates to invigorate demand in the system. The currency carry trade becomes a turn off to the FIIs. Also, investors prefer equities over debt securities, as the coupon rate bear lower returns, during the growing phase. The departure of FIIs leads to a supply glut, which bogs down the exchange rate.
What drives inflation?
There are several factors in an economy that contributes to an increase in price. But, it all boils down to one thing — whether demand is higher than supply.
Its a classic phenomenon in a super hot economy. The growth rate thrives, as a result, the demand surges and exceeds the supply. There are four factors which fuel demand.
#1 Expanding Economy
During the expansion phase, the economy deploys maximum workforce available to use. The skilled workforce becomes a hard catch too. So, entities splurge on the superlative manhunt.
Further, they pay more to retain the workforce. In a nutshell, the labor pool draws more wages, which boosts their spending capacity.
#2 Government spending
The government can spend on an array of venues. But if it allocates the resources on welfare measures, infrastructure and skill development, it results in an upward shift in aggregate demand.
Welfare measures aim at improving the live standard of commoners and subduing the parity between rich and poor. The relief measures generally tend to be providing cash support or job creations.
Infrastructure development increases the efficiency of the economy. It propels the demand in the short-term as well as long-term.
And skill development is a deep-rooted project which aims at deploying quality workforce in the economy. It strengthens investor confidence, which draws further inflow.
#3 Increased money supply in the system
Although the printing of money, per se, does not instigate inflation, it contributes indirectly.
For instance, consider the quantitative easing program. The central banks used the freshly minted notes to buy bonds (mostly G-Sec) which had two implications. One, it increased government spending. Two, it increased the bond yield bringing down the long-term interest rate. So, long-term investors found solace in the equity market, which cut down the finance cost of entities. Entities flourished, jobs increased, which led to the resurge in purchasing power of the economy.
When people believe prices are to rise in the future, they tend to procure the goods at the lows and accumulate. The preemptive buying activity can drag the price higher.
When the cost of production increases, entities pass the effect on consumers by raising the prices. There are four factors which can increase the production cost.
Wages and salary are significant overhead costs. Firms have no other option than to increase the price to meet the growing demand of their employees.
When the input increases by ‘x’ times, to counter it, the output must also increase ‘x+’ times. Else, profitability and sustainability become a question.
Tax levies and tariffs are add ons, which a consumer has to pay off in the counter. These do not cause volatile price swings as they are mostly a one-off addition.
Commodity pricing does not refrain to domestic markets. The prices are fixed globally. So, when the exchange rates squabble, the local prices sway as well, which influences purchase decisions. For instance, consider you’re living in the UK and the value of cable goes down. As a result, crude oil, which is traded in dollar spikes up in your local market. Naturally, you either cut down your spending in fuel or other expenditures as oil expense draws down your purchasing power.
Who measures inflation?
In the US, the Bureau of Labor Statistics measures inflation. They create a basket measure the change in price from two perspectives — buyer and seller.
Consumer Price Index (CPI)
As the name suggests, it measures the price change from a buyer perspective.
The basket of CPI contains essential commodities like food, gasoline, automobile, housing, transportation and other amenities.
It can enumerate the cost of living in the economy and defines the inflation level of the economy.
Purchase Price Index (PPI)
PPI, aka wholesale price index (WPI), measures the price change from a producer perspective.
The PPI basket differs in its entirety to CPI basket as it measures the raw materials and unfinished goods, which are sold off to another producer.
It portrays the purchasing power of the business community.
The investing fraternity always keeps tabs on inflation. Because, at times, it can make a mockery out their returns. If you’ve invested in fixed income securities, say bonds or term deposits, then inflation rates are even dearer to you as they are more vulnerable to its changes.