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Inflation – definition, cycles, and opportunities

Inflation is one of the main macroeconomic drivers of the financial markets. Here is everything that you need to know about it.

Inflation is one of the main macroeconomic drivers of the financial markets. It usually cycles between low and high inflation periods, leading to central bank intervention and causing significant long-term market trends in many assets. There are several indices tracking inflation, as listed below.

Main inflation indices

The Producer Price Index (PPI) measures the average change over time in selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.

In other words, imagine you own a business, and for your firm to produce some goods, you need to buy other goods. For example, you operate a steel factory. For steel alloys to be produced, you need to buy iron. Therefore, your business is entirely dependent on iron prices. If iron prices go up significantly, it will likely lead to higher costs for your company, squeezing your profit margins.

The PPI is sometimes called input inflation. As a result, you need to monitor the costs of your inputs, in this case, iron, to β€œhedge” against inflation. Either you will enter into some form of derivative contract, or you will hike the prices of steel you produce, passing the inflation onto your buyers.

On the other hand, the Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It is sometimes referred to as output inflation.

That is, what consumers pay for goods and services they frequently buy – the cost of food, drinks, energy, utilities, cars, clothes, IT, services, leisure activities, and so on. In other words, how much more will you likely pay each time you visit a grocery store, a theatre, or a utility bill comes into your mailbox.

Usually, the PPI is a leading indicator of future inflation for consumers as it always takes some time for rising inputs to transform into increasing outputs.

There are other inflation indices, such as PCE indices (in the US) or the HICP index in Eurozone. Those are less known, although still important. Moreover, the calculation is slightly different (they might consider other goods and services). Still, overall, the PPI and CPI indices should be the best representation of the overall inflation situation. They are released once a month across all the developed countries.

How does inflation impact markets?

Questions like these are always tricky to answer as several other factors also influence the markets. For example, if there is a long-term rise in inflation (such as in 2022), the domestic currency tends to depreciate. Then, however, traders start pricing in rate hikes and other forms of monetary tightening to stop inflation. That usually leads to a stronger currency overall.

For short-term trading, it is nearly impossible to predict how the markets will react to any given CPI/PPI number.

From the long-term perspective, it is usually like this – if inflation rises above the central banks’ target of 2%, yields start generally going higher, with rate markets implying future rate hikes, strengthening the domestic currency.

On the other hand, if inflation remains considerably below the 2% target, the situation reverses – traders start buying bonds, pushing their yields lower, leading to monetary policy easing and devaluing the domestic currency.

Therefore, it is crucial to analyze the current inflation trend and how it will impact your portfolio. For long-term investors, many opportunities arise when correctly predicting inflation, central banks’ actions, and long-term trends in the (stock) markets.

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