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Why Inflation Matters to Traders?

12 May 2020 By Mircea Vasiu

Later today, the Consumer Price Index (CPI) in the United States is forecasted to show a decline.  This is expected both the Core CPI (excluding food and energy prices considered too volatile and thus distorting the data) and the headline CPI present no worries about inflation anytime soon.

The Fed, many believe have done a great job thus far to fulfill its dual mandate of job creation and price stability. Prior to the coronavirus pandemic, the economy ran at almost full employment levels. As for inflation, the median three-year expected inflation rate just hovers around the 2% level.

2% – The Line in the Sand for Modern Central Banking

Introduced by the Reserve Bank of New Zealand (RBNZ) a few decades ago, the inflation target was quickly embraced by other important central banks in the world. Nowadays, the consensus exists that inflation below, but close to 2%, is enough to spur growth and stimulate a sustainable rate of it.

The big question for many traders is why 2%? Why not, for instance, 0?

The answer comes from the perceived inflation expectations. If the inflation rate drops to zero, or, God forbid, below zero, the economy enters a deflationary stage.

Suddenly, inflation expectations drop in a spiraled move as people expect lower prices – thus, postponing consumption. With no consumption or lower consumption, the economy stalls – and eventually will start to decline. Hence, moderate inflation of 2% is viewed as high enough to stimulate consumption, and low enough to not affect the intrinsic value of money.

Today’s releases, while expected to have a negative sign, do not show deflation. One of the common errors made by rookie traders is to misinterpret declining inflation (i.e., disinflation) with deflation. If inflation drops from 5% to 3%, the Core CPI will have a negative sign in front of it, but the inflation rate is still positive. Only when inflation turns negative, we can talk about deflation.

Traders do care about inflationary/deflationary economic concepts. As they are part of central banks mandates, changes in inflation lead to interest rate changes. The latter cause dramatic shifts in the value of a currency and the overall exchange rates displayed in Forex markets.

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