Every central bank has a mandate that revolves around price stability. In economic terms, price stability means inflation is being kept at bay. Studies show that for healthy and constant economic growth, inflation levels must be limited. More specifically, major central banks consider inflation to be limited when it is close to, but below, two percent.

The Consumer Price Index (CPI) measures inflation. Released monthly in all economies, it shows the change in values of all goods and services over the last month. Because central banks try to maintain price stability, changes in the CPI can trigger massive reactions in the currency market when inflation misses its target. Take the GBP‘s response to a lower-than-expected CPI, shown below.

While the UK’s CPI is slightly higher than the two percent target, the actual release missed market expectations (2.4% vs 2.6% expected) and consequently, investors instantly sold GBP across the board. The chart above shows the GBP/USD reaction as it lost over a hundred pips after the weak release.

Deflation and why it matters more

If inflation measures the increase in prices, deflation does the exact opposite.

The problem with deflation comes from central banks having fewer monetary tools to fight it. They don’t like the term deflation as it is considered too scary and therefore use the term “negative inflation” instead, defined as when the inflation rate falls below 0% and becomes negative. As a result, instead of the price of goods and services rising, they fall.

As mentioned earlier, when there is no inflation, the economy stalls. Hence, deflation is more disruptive than inflation, as it curtails economic expansion. The best example comes from Japan. For more than a couple of decades, the Japanese economy has been fighting a terrible deflationary cycle. A deflationary cycle can lead to a full economic downturn due to a combination of factors: people tend to spend less, as spending declines inventories rise, factory orders decline, people lose their jobs, etc.

In the end, deflation or inflation indicates the progress made by the central bank to restart the economic engine. After the 2008 financial crisis, the price of oil dropped from over $100 to below $30, and a deflationary wave gripped the world. It took almost a decade for major economies to return to a state of sustained economic growth, and the measures taken by central banks varied based on the type of their economies.

For instance, Quantitative Easing (central banks buying their own government bonds) provided excellent results in the United States, but not so great in Japan. To summarize, keep an eye on what the CPI shows, as it is the number one economic release all central banks interpret before modifying the interest rate level.

Main Takeaways

  • Inflation shows the change in the price of goods and services in a given period.
  • Deflation is also referred to as “negative inflation”.
  • Deflation is more difficult to tackle than inflation.
  • Deflation happens when the prices of goods and services are falling.