We have all experienced inflation at some point in our lives. It seems that the price to attend college only seems to go up and never declines. Tolls on the highways and fees for the subways are a one-way street higher. If you trade the forex markets, you are likely to come across several inflation reports. The question you might be asking yourself is why are these reports essential, and what should I know about them to make an informed trading decision.
What is Inflation?
Do you ever feel like the money you make does not buy as much as it used to? You might feel this way if inflation is occurring. Inflation happens when the price of a good or service rises. Inflation is not bad or good, but it can impact you when it increases at a rate that is faster than the increases in your income.
Inflation is generally defined by the increase in the price of a basket of goods and services. The rise in inflation is usually related in percentage terms. For example, you might see that inflation is rising at 3% year over year or 0.5% month over month.
There are several definitions of inflation. The most common describes a basket of goods and services. When a government issues an inflation report, it will often have multiple components. There will be a headline number that describes all inflation. There could also be a component that removes food and energy, which are usually more volatile. When inflation is calculated without a food and energy component, it is often called core inflation. The factors that drive core inflation are home prices and labor costs.
What is an Inflation Report?
Inflation rate reports are regularly scheduled by governments describing price levels and how they might impact consumers. Most countries provide information about consumer inflation, what you pay at the retail level, and producer inflation, which is paid at the wholesale level.
Who Controls Inflation?
Inflation naturally occurs within an economy, and some appointed officials are in charge of controlling inflation. Most central banks have a mandate to control inflation. The goal is to keep inflation at a steady rate and avoid allowing prices to rise faster than growth. For a country to grow at a sustainable pace, inflation needs to occur. Typically, inflation is generated by strong economic growth.
A central bank will control inflation using monetary policy. They will alter interest rates using the tools at their disposal to keep inflation within a well-defined band. When inflation rises faster than expected, a central bank will increase interest rates to reduce future inflation. When inflation is slowing or declining, a central bank will often lower interest rates to spur growth and price increases.
As a trader, you want to track inflation since changes can impact central bank activity. The way to track inflation is through reports released by governments. Each inflation report will have a slightly different nuance, which can provide you with specific inflation about future interest rate movements.
There are several different ways to report on inflation figures. The inflation that will impact you and your family is inflation at the consumer level. If you drive to work every day, rising gasoline prices will take more out of your paycheck. There is also inflation that occurs on intermediate goods that you don’t use but can spill over into consumer inflation. For example, gasoline is refined from crude oil. If crude oil prices rise, it will lift the price of gas. Intermediate good and service inflation is measured at the producer level.
Each country uses inflation reports to relay past inflation information. For example, the most well-known U.S. consumer inflation report is the monthly consumer price index (CPI). The U.S. Labor Department issues the CPI report. The U.S. Labor Department also announces the most widely viewed wholesale U.S. inflation report. This report is called the Producer Price Index report. The PPI report is published monthly. In the United States, another widely watch report is the Personal Consumption Expenditures report. This inflation gauge is released by the U.S. Commerce Department and is known as the Federal Reserve’s preferred inflation gauge.
In the United Kingdom, the Bank of England (BOE), produces a quarterly inflation report called the BOE Inflation Report. The Bank of England (BOE) Inflation Report provides inflation projections to the Monetary Policy Committee. The MPC then bases its interest rate decisions on assessing future U.K. inflation over the following two years.
How Does Inflation Occur?
Inflation occurs for several reasons. When demand is more significant than supply, prices will naturally rise until it reaches an equilibrium price. Demand can outstrip supply for two reasons. There can be a supply disruption, which can also happen for several reasons, or demand could surge. Supply disruptions can occur because of natural disasters such as a hurricane. They can also happen because of war or unstable government. Rising demand generally occurs when economic growth accelerates.
You don’t want to evaluate inflation as just higher prices for just one item or service. Inflation refers to prices across an industry. Recently within the US, the auto industry was facing a crisis as it did not have enough semiconductors to produce finished cars. The shortages forced some major car companies in the United States, such as General Motors and Ford, to slash production. To help alleviate the drought, the Government asked big semiconductor manufacturers and their host nations, including Taiwan, to increase output.
This lack of supply created a crisis in the making. Demand for chips had been rising due to the increasing demand for small electronic devices. The supply shortfall came due to the Covid 19 pandemic and the cold weather that hit Austin, Texas, which forced two U.S. domestic chip manufacturers to close. Unfortunately for consumers, the slowdown in automobile production had significantly reduced car inventories putting upward pressure on prices.
Breaking Down an Inflation Report
When inflation is rising or falling, your attention to inflation reports becomes essential as it can quickly impact interest rate levels. The U.S. produces three significant reports that focus on inflation, including the Consumer Price Index, the Producer Price Index, and the Personal Consumption Expenditures Index.
The Department of Labor calculates the Consumer Price Index by determining price changes for a basket of hundreds of goods and services. There is an intermediate step that is a report where the Department calculates changes to the prices in sectors or industries, and this data is available for 28-years.
Traders will often evaluate headline inflation relative to core inflation. Recall headline inflation includes all goods and services. Core inflation (also referred to as ex-food and energy) eliminates the food and energy components, which are more volatile. While the headline numbers steal the glory, it’s the core inflation figures where you should focus your attention. While the Federal Reserve preferred gauge is core personal consumption expenditures, the core CPI mimics the results to some extent. Over time these gauges are correlated. If the core consumer price index report begins to accelerate, core PCE will likely rise.
Core CPI reflects rising wages and rising housing prices or rent equivalents. When your wages increase, you are more likely to purchase more goods and services. If wages move higher, there will be more competition for specific items and put pressure on prices. If wages begin to fall, you are less likely to try to “one-up” another bidder for a good or service, and prices will start to decline.
The American Dream is homeownership, and with higher wages, you might be interested in purchasing a home. When inventories are low and housing prices rise, homeowners can gain more purchasing power by using their equity in their homes to take out a loan. As more people take home equity loans, the amount of money moving in the economy rises, pushing up prices and generating inflation.
Similarly, the Labor Department report of the core Producer Price Index tells you more about overall inflation than the headline number. This report also excludes food and energy and tells you about intermediate core inflation.
Personal consumption expenditures (PCE) measure the price at which consumers are spending. The PCE Price Index uses the personal consumption expenditures component of the Personal Income and Outlays report. This report is the preferred Fed inflation report.
How Central Banks Deal with Inflation
Most central banks worldwide, including the Federal Reserve, the Bank of Japan, the European Central bank, and the Bank of England, control inflation as part of their mandate. The Federal Reserve, for instance, has maximum employment and steady inflation as their mandate from Congress. To handle their orders, central banks will generally use the tools at their disposal, including short-term borrowing rates.
Each business cycle is different, but there is usually a common theme. As growth increases and inflation starts to rise, a central bank will increase short-term interest rates to choke off increasing prices. As economic output starts to decline and inflation begins to fall, a central bank will reduce short-term interest rates to boost growth and inflation.
Central banks generally control short-term borrowing rates. For example, in the United States, the Federal Reserve controls the Fed Funds interest rates. The Federal Funds rate is the rate where banks lend to one another. In regular times, the Federal Reserve does not control other interest rates, such as long-term Treasury bonds or mortgages. Market participants influence these interest rates. If market participants believe the Federal Reserve will be increasing short-term borrowing rates in the future, they are likely to push up long-term interest rates.
Therefore, the future action of a central bank is pertinent to a trader. Traders speculate on what a central bank might do in the future and how that will impact market rates. These rates will also impact currencies. When rates rise in one country and are stable in another, the country’s currency with increasing interest rates is likely to outperform.
The movement of interest rates and currencies due to central bank activity leads a trader to inflation reports. Since inflation is a crucial mandate for most major banks worldwide, a trader needs to watch the different inflation reports released closely.
What Assets Outperform and Underperform When Inflation is Rising?
When inflation begins to rise, specific assets will outperform, and some will underperform. The Assets that will exceed when inflation starts to increase are:
- Inflation-Protected Securities
- Late Cycle Stocks
Commodities are fungible assets and can be delivered to any location as long as the product is standardized. Oil, gold, agriculture, and base metals are products that are generally considered commodities.
The commodity that is usually most associated with inflation is gold. Gold is an alternative currency, and when inflation begins to rise, gold is considered an attractive hard asset that will keep its value. Other hard assets, such as oil, and agriculture can outperform when inflation begins to accelerate.
To take advantage of rising inflation, you can purchase commodities using futures contracts, ETFs, or even CFDs. You might also consider purchasing physical gold and silver bullion or coins. Futures contracts are products that allow you to own the right to buy a commodity at some date in the future. These products are regulated and trade on a futures exchange such as the Chicago Mercantile Exchange. You can also purchase an Exchange Traded Fund (ETF). These are products that will hold other products in a trust like commodities. For example, the GLD (SPDR Gold Shares Trust) has gold futures contracts.
There are also specific inflation-protected securities that will increase in value when inflation begins to rise. For example, Treasury Inflation-Protected Securities (TIPS) will track the U.S. Consumer Price Index’s movements. This inflation value is embedded into the price of the bond.
Some late-cycle stocks also outperform during rising inflationary periods. Commodity producers like oil companies and miners are examples of companies that will exceed when inflation begins to accelerate higher.
What Assets Underperform When Inflation Starts Rising?
Higher inflation generally leads to higher interest rates which can erode the value of bonds and stocks. Bond yields are a reflection of the interest rates they provide to the purchaser of the bond. When you purchase a 10-year Treasury bond at 3%, you receive 3% of income for lending your money to the U.S. Treasury. When the rate on the bond rises, the price moves in the opposite direction and declines.
Stock prices also usually underperform when inflation rises in tandem with interest rates. Equity values are discounted cash flows of the future earnings of a company. If the company is making the same amount of money but interest rates rise, the discounting mechanism will reduce the current value of future earnings. Therefore, most early cycle and mid-cycle stocks will decline in value when inflation is growing along in tandem with interest rates.
The Bottom Line
The upshot is that inflation reports are a crucial part of trading the forex and capital markets. Inflation reports describe inflation at the wholesale and retail level and are part of nearly all central bank mandates. The outlook of future inflation expectations will drive monetary policy decisions. Traders will then use these expectations to determine future interest rates, controlled by market participants, which will spill over into the currency markets.
The currency markets are driven in the long run by interest rate differentials. The interest rate differential is the difference in the borrowing rates in each country’s currency. Interest rate differentials are used to generate the forex forward curves and influence a currency pair’s direction.
If inflation is beginning to accelerate at a rate that is faster than the benchmark created by a central bank, they will typically increase short-term borrowing rates. As a trader, it’s your job to speculate on whether this will occur, and you can do that by evaluating inflation. Alternatively, if inflation is falling, there is a chance that a central bank will reduce interest rates.
Most of the capital markets are impacted by changes in inflation expectations. For example, higher inflation in the United States can lead to higher borrowing costs, which can lower Treasury bonds’ value. These higher rates can also impact the interest-rate differential, which will also make the dollar more attractive. When interest rates rise, the present value of future cash flows will decline, reducing the weight of a company’s future earnings. This scenario will harm early and mid-cycle stock prices. Commodity prices will often get a boost from higher inflation expectations. Treasury Inflation-Protected Bonds that will benefit from higher levels of inflation.
There are several parts to inflation reports. In addition to consumer inflation and wholesale inflation, there is also headline inflation and core inflation. The former includes every sector from a basket of goods and services. Core inflation removes the volatile food and energy components. The bottom line is that inflation expectations play a vital role in determining many capital market assets’ future values.