Everything The Trader Needs To Know About Inflation

By March 16, 2018Trader Tips

Fundamentals. Technical analysis. Historical data. Candlestick charts. These are all things that a trader needs to make informed trading decisions, right? But there are also macro factors to consider, such as GDP, interest rates, and, above all, inflation.

Let’s first do a quick overview of what inflation actually is.

Inflation is the rate at which consumer prices of goods and services increase over a certain period of time, commonly a month or a year.

Alternatively, inflation is defined as the decline in the purchasing power of a unit of currency. Inflation is the standard path any economy follows over longer periods of time: a quart of milk today in the U.S. costs significantly more than it did back in, say, the 1930s. That’s because, on a longer time scale, the economy grows irreversibly, despite crashes and depressions.

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That said, there are three usual drivers of inflation:

  • demand-pull
  • cost-push
  • oversupply of money

Demand-pull and cost-push are the most common drivers of inflation. Whenever the demand for goods and services starts exceeding supply, we have demand-pull inflation. Whenever the production costs for a good or service rise, or alternatively, an external event constricts the supply of a certain good or service, we have cost-push inflation.

When an economy grows, so does the purchasing power of individuals–usually. The more money there is to spend, the more willing people are to pay higher prices for goods and services. That’s demand-pull inflation. However, when there is too much money—as is the case when a central bank intervenes to stimulate economic growth—we have monetary inflation.

Monetary inflation boils down to this: money is a commodity like oil, or gold, or wheat. The more there is of it, the less it costs. Cheaper money means lower purchasing power, and lower purchasing power equals inflation.

So, how is all this important for traders? Well, it’s important because depending on the rate of inflation and future inflation trends, you can select stocks, currencies, and other assets to trade that will bring you greater profits.

 

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Take Forex trading, for example. When an economy grows, interest rates grow, too. The higher the interest rates, the higher the value of this economy’s currency. The greater the value of a currency, the more you could make trading it.

Yet, this is the case only when GDP grows too. If it is declining, then the high-interest rates will pressure the value of the currency, which is why it’s important for currency traders to keep an eye on economic growth developments in the countries whose currencies they trade in.

Yet currency traders are not the only ones for whom inflation is important. Equity traders should keep an eye on inflation trends, too. When inflation is higher (and accompanied by economic growth), cyclical stocks, such as tech companies and industrials, do better. Defensive stocks, such as utilities and telcos, do worse. That’s because they tend to behave more like bonds, in that they carry stable dividends (think fixed income).

So, right now, the economy in the U.S. is recovering. The recovery is uneven, sure, but it is happening, and the Fed has hiked interest rates twice already. This has pushed up the greenback while dampening the appeal of the ultimate safe haven: gold. If you’re a gold trader, these latest inflation developments in the U.S. can be essential for your future trades: these developments will help you to predict more accurately where gold prices are heading and make a winning trade.

Now that you’re aware of how important inflation can be for your trading decisions, make sure you also bear in mind some variations.

  • While inflation is pretty much the standard for any economy, if that economy slips into recession, inflation could turn into deflation. Recessions lead to lower demand and lower demand leads to lower prices. When prices fall, a deflationary spiral kicks in people start hoarding their money, waiting for prices to fall further. This hoarding hits businesses, and stocks prices fall, too.
  • Besides deflation, which is perhaps the most common variation, although it occurs relatively rarely and lasts for only short periods of time, there’s also stagflation, which combines high inflation with economic stagnation; hyperinflation, which is rarer still; and disinflation, which is often a warning sign of deflation coming.

Knowledge about inflation and its variations is important not just for economists. It’s a valuable decision-making tool for traders, too, even if you prefer to watch the charts and make intuitive decisions. You probably know by now that intuition is not always the best advisor. Hard facts such as inflation rates and trends are a much better basis for trading choices.

 

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