A Forex View From Afar

The Fed, Inflation, and the Blame

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Inflation is the loss of purchasing power of any given currency and/or the general rise in prices. The "or/and" is because even great economist can't give an exact definition of inflation because of its "hidden ways" to appear and its diverse outcomes.

But what economist have agreed upon is that inflation is seen as a necessary evil. We can't have growth without some inflation; but too much seriously affects the economy. The 1980 crisis’ were caused by inflation, economists say.

Inflation has been among us from the longest times; its first recording are from the Roman Empire. By replacing the amount of silver in the Roman coins, with other cheaper raw materials, the Roman population started to lose its faith in coins.

Inflation sources vary, and its effects are wide ranging, and this has been creating a big debate and has split the economist’s word in two big camps: Keynesian and Monetarist.

This is not the place to be continuing this debate, after all we are trading and not writing economy essays. It may be worth mentioning however that the Keynesian group puts the cause of inflation on the shoulder of aggregates demand (meaning goods and services). At the same time the Monetarist approach took form, lead by Milton Friedman, saying that inflation may be caused by an increase the money supply relative to the money demand.

The modern view of inflation is viewed as a combination of both Keynes and Friedman’s work, but in modern times it now tends to lean more towards Friedman.

Forex Traders use Consumer Price Index data to measure inflation in the US, and the Harmonized Index of Consumer Prices to measure inflation in Europe. Since all major Central Banks have inflation target strategies, inflation is very important for Traders. It is important to note that Fed does not have an inflation targeting strategy, but even Mr Bernanke is a well-known promoter of inflation targeting.

If a Central Bank, through various methods, sees inflationist pressures it will take constraining measures on the economy, like raising Interest Rates, by reducing credit availability or by fiscal policy. Researchers have shown that monetary politics will need, on average, 18 months (over 4 quarters) to take effect.

This means that the cause of the Inflation that we see today is probably because of poorly taken monetary decisions over the last year and a half, or from extremely unusual commodity price moves; it is one or the other it seems.

Traders can be heard to say that a Central Bank will not raise or cut because of the currency impact. This is a wrong judgment; the role of a Central Bank is to watch inflation and not to monitor the currency market (which is a free floating environment). Central Banks have thousand of way to influence the currency market, starting from the simplest, like verbal intervention, to more complicated and complex schemes. Interest rates are raised/lower due to inflation anticipation.

Massive inflation is called hyperinflation, this usually happens during wars. The worst of all form of inflation is stagflation, in which inflation is high and the growth is either very small or negative. High inflation requires high interest rates, while to promote growth over medium-long term lower interest rates are required. This is what makes stagflation so difficult to cure.

The opposite of inflation is deflation, what the Japanese economy has been struggling for decades with now.

Socially, inflation is the population’s loss of faith in money, and thus a loss of faith in the Central Bank. This is a major event and must be avoided with all costs. Welcome to the world of the Federal reserve; a cut in rates is needed to stave off a Housing recession, but a rate increase is also required to tame inflationary Energy costs.