Inflation VS Global Financial Markets
The impact of different levels of inflation on global financial markets and how its measured
Inflation is a significant concern for global markets
Central banks aim to curb the ongoing inflation spike
Inflation is measured through the CPI
Factors causing inflation include an increase in money supply, demand, production costs, government policies, exchange rate fluctuations, and expectations
Inflation VS Global Financial Markets
Inflation is the common theme taking over markets right now and is the biggest battle central banks are fighting against, to curb the 40-year spike in recent inflation figures that fumed markets in 2022. As central banks resorted to the tool of hiking rates aggressively, pushing the economic outlook into a bleak area, initiating worries of recession.
Inflation in the United States of America reached levels of 9.1% in 2022, while inflation in the European Union reached 10.6%, And in the UK which suffered the most hitting an astounding level of 11.1%. Inflation is considered high by measuring the reality of it against the internal levels of inflation within economies, as the policy tries to make inflation revolve around a fixed rate.
In the United States, the inflation target for the Federal Reserve is jotted at 2%. This means that companies can increase prices by 2% each year, and the market will still be competitive. Workers can also request a 2% wage increase based on these increases so that they can afford the costs of goods and services. However, inflation in the United States rose several times far from the Fed's target as mentioned above.
While it is easy to see and measure price changes in real life, it is another thing to actually understand them. Inflation can affect many things besides costs, such as employment and wages.
What is inflation?
Inflation refers to a sustained increase in the general price level of goods and services over time. In other words, the purchasing power of the currency is decreasing, and it takes more money to buy the same amount of goods and services than it used to.
Inflation can be caused by a variety of factors, including an increase in the money supply, which results in more money buying the same amount of goods and services, as well as supply chain disruptions, changes in demand, and changes in government policies.
Moderate inflation is generally considered a sign of a healthy economy, but high or unstable inflation can harm the economy and people's standard of living.
Governments and central banks often attempt to manage inflation through various policies, such as adjusting interest rates, controlling the money supply, or implementing fiscal policies that affect spending and taxes.
Inflation is measured through the Consumer Price Index (CPI), which tracks the prices of a basket of goods and services that a typical household might buy. When the consumer price index goes up, it means that the cost of living is going up, and the purchasing power of the currency is going down.
What are the causes of inflation?
The most common reason is that "the total economy exceeds spending on the economy's relative ability to produce goods and services." Inflation in a large economy can also be caused by a variety of factors, including:
- Increase the money supply: When the central bank increases the money supply in the economy, it can cause inflation. This is because when there is more money available in the economy, there is more demand for goods and services, which can cause their prices to rise.
- An increase in demand: When the demand for goods and services exceeds the amount of supply, this can happen when the economy is growing rapidly and people have more money to spend, or when there are supply chain disruptions that limit the availability of goods.
- Increase in cost: An increase in the cost of producing goods and services can cause inflation. This can happen when there is a shortage of raw materials or labor, or when energy prices rise.
- Government policies: such as taxes or subsidies, can affect prices and cause inflation. For example, if the government increases taxes, the cost of goods and services may increase.
- Exchange rate fluctuations: Changes in exchange rates can also affect the prices of goods and services. If a country's currency depreciates in value compared to other currencies, this can lead to an increase in the cost of imports.
- Expectations of future inflation: Inflation can also be caused by expectations of future inflation. If people believe that prices will continue to rise, they may demand higher wages and prices for goods and services, which may eventually lead to an actual cycle of inflation.
It is important to note that inflation is often the result of a combination of these factors and can be complex to understand and manage. Central banks and governments often use a combination of tools and policies to try to control inflation and maintain economic stability. A tightening cycle is the most common method of trying to curb inflation.
How is inflation measured?
Inflation can be measured by comparing the current price of goods and services to their current date over a period of a month or a year. Countries usually measure inflation through a variety of methods and influential economic data. Here are some of the most popular ways:
- Consumer Price Index (CPI): The Consumer Price Index released by the US Bureau of Labor Statistics measures the prices of goods in the market, which represents more than 90% of the American public. The CPI looks at a "fixed basket" of about 80,000 goods and services. What goes into this basket is based on a Consumer Expenditure Survey that polls Americans to identify important items. The importance of these goods then determines their weight in the consumer price index - for example, the price of something like petrol which is an integral part of many people's costs of living will contribute more than other items.
- Price Index of Personal Consumption Expenditures (PCE): This measure from the Bureau of Economic Analysis takes a more comprehensive view. Rather than calculating the change in prices of goods paid only out of pocket for consumers, the index considers all expenditures, including health care coverage that is compensated by insurance, and is the Fed's preferred measure of inflation.
- Core CPI: This is a term used by economists to reflect the rate of inflation excluding food and energy prices, which are notoriously volatile.
- Producer Price Index (PPI): The average change over time in the prices that producers receive for their goods and services. The PPI can be used as an early warning signal for inflation, as it can indicate whether producers are facing higher costs which can be passed on to consumers by increasing prices.
- GDP deflator: The GDP deflator measures changes in the prices of all goods and services included in the GDP. It can be used as a proxy for the CPI, especially for countries where a large share of the economy is not included in the CPI.
- Surveys: Some countries use surveys to collect information on prices and inflation. For example, in some developing countries, government officials go to markets and shops to collect price information on a regular basis. In other cases, household surveys can be used to collect data on the prices of goods and services purchased by households.
- Financial indicators: In addition to these traditional methods, some countries use financial indicators, such as interest rates and exchange rates, to track inflation. For example, if interest rates rise, it may be a sign that the central bank is trying to control inflation.
Major economies in the current economic situation follow the CPI print to determine the country's inflation situation. The latest US Consumer Price Index report, released on February 14, 2023, indicated a 0.5% rise in January on a seasonally adjusted basis. While the index rose by 6.4% on an annual basis.
The shelter index (housing cost) was the largest contributor to the CPI increase. This means that Americans pay more on rents and mortgages, and food, gasoline and natural gas were also contributors.
Will inflation lead to a recession?
It is possible that inflation will cause a recession, but this is not always the case. Indeed, the relationship between inflation and recession can be complex and depends on a variety of factors, including the root causes of inflation and how policymakers respond.
In some cases, inflation can be a symptom of an overheating economy, where there is huge demand for goods and services, which drives up prices. In this scenario, central banks may raise interest rates to calm the economy and reduce inflation. However, if interest rates are raised too quickly or dramatically, it can lead to less borrowing and spending, which could lead to a recession. This is what we are currently experiencing, so fears of a specter of recession are always present in markets.
It should be noted that a moderate level of inflation is generally seen healthy for the economy, as it can indicate growth and support for business profits and wage growth. High and persistent inflation can be harmful because it undermines the value of savings and investments, discourages long-term planning, and can lead to a decline in business and consumer confidence.
A recession is not defined by a GDP indicator entering negative territory for a quarter or two. Rather, it is a significant decline in economic activity caused by several factors, including high unemployment rates, a slowdown in goods being produced and sold, and lower wages in addition to negative GDP readings.
This is according to the National Bureau of Economic Research, which gives the official verdict on when the recession in the United States will start and end.
So... inflation can lead to a recession, but it is not a definite outcome