What is inflation?
Inflation is one of the most important factors when deciding on interest rate changes and is watched closely by the central banks. Inflation is the speed of which goods and services are rising, it is closely watched because prices either rising too fast or too slow can be harmful in the long term. Inflation is measured in percentage with central banks generally aiming for 2% per year meaning each year the same goods and services increase in price by 2%.
What are the effects of inflation
When inflation is rising too fast this means the purchasing power of your money is also falling fast. This also means savings are loosing purchasing power, is you have a savings account giving you 0.5% interest a year and inflation is 2% you are effectively loosing 1.5%, but if inflation is increasing too fast for example 3% you are now loosing 2.5% on your savings purchasing power. High inflation also means your wages are worth less each year, the same wage one year will buy you less the next and although pay rises will help if inflation is 3% and you get a pay increase of 1% you still have 2% less purchasing power from the year before.
When inflation falls this also can cause problems, slow inflation means a slow economy, this reduces the interest from people and businesses from investing in the economy. Slow inflation can also lead to higher unemployment due to low investments from businesses and also wage cuts, and while it increases your money purchasing power this often causes people to save more and spend less due to purchases possibly being cheaper in the future but this slows the economy further leading to further deflation.
How to trade using inflation
Inflation figures can cause big moves in the market both short term and longterm so it is a good ides to keep an eye on inflation when trading forex. When inflation is rising too fast the central banks will raise interest rates to encourage saving and reduce spending due to high borrowing costs, this is to lower inflation and slow down the economy to a steady and healthy pace. The opposite also happens when inflation falls to fast, interest rates are cut to reduce saving and increase spending helping the economy speed up back to a healthy pace.