Inflation is the primary concern of a central bank. More precisely, all the central banks in the world change the interest rate level based on inflation. In economic terms, inflation is called CPI or Consumer Price Index. Released monthly and yearly, it shows the change in the prices of all goods and services over a defined period. Part of a central banks’ mandate is to keep inflation under control and to ensure there is price stability in the economy.

This is not to be confused with currency trading. Investors often wrongly assume that price stability is achieved by central banks intervening on the currency market and creating ranges so that the currency doesn’t move. This is wrong. Price stability refers to central banks’ ability to keep inflation under control.

Inflation as part of a central bank’s mandate

Central banks in capitalistic economies have a mandate to maintain price stability. Effectively, this means that they target an inflation level below – but close to – two percent. It is not detrimental to the economy if the inflation level, or the CPI, rises a little above two percent, as the price stability mandate would have been fulfilled. The concept is for central banks to not to allow inflation levels to overshoot the target (rise too much, too fast) or undershoot it (fall too much, too fast).

The correlation between inflation levels and trading activity is typically as follows: when inflation falls below the target rate, investors often look to sell the currency. The market may then start to expect that the central bank will cut interest rates to stimulate economic growth. Because the CPI or inflation data is released within the period that falls between two central bank meetings, investors usually react quickly and do not wait until the central bank changes the monetary policy. Instead, investors typically position themselves earlier, based on what the inflation data shows.

Inflation comes in two releases: one on the producers’ side (PPI – Producers Price Index) and one on the consumers’ side (CPI).  A common theory amongst market participants is that when inflation rises or falls, it will first appear on the producers’ side, and secondly in consumer prices. From an economic cycle perspective, this theory makes a lot of sense. For this reason, investors look at the PPI trends and expect a similar move to follow on the CPI.

Few investors know that oil prices have a strong inflationary component. Lower oil prices bring lower inflation, while higher oil prices trigger higher inflation levels. For this reason, the price of oil is on every central bank’s radar. To eliminate the temporary effects oil prices have on other prices, many central banks consider only the Core CPI. The core CPI, or the core inflation, measures the changes in prices, excluding energy prices and, in many cases, food prices. Both energy and food prices are considered too volatile, and as such, may have the effect of distorting the overall data.

Inflation can turn negative too. When inflation levels drop below zero, deflation grips an economy. This scenario is more difficult to correct as consumers drastically curb their overall spending.

To summarise: the more inflation rises above the two percent, the higher the interest rates are likely to rise. The more it drops, the lower the rates will become. Whatever the direction, central banks hope that trust in their money isn’t lost. If it is, hyperinflation can occur as seen in Venezuela and Argentina, or conversely, decades-long deflation can occur as seen in Japan.

Take-aways:

  • Central banks strive for price stability.
  • Price stability refers to keeping inflation around the desired level (target).
  • Two percent inflation is a standard mandate for a central bank.
  • Higher inflation triggers higher interest rates; lower inflation triggers lower interest rates.