Inflation

Inflation is the general rise in prices across an economy over time, which reduces the purchasing power of money. A little inflation is considered normal and even healthy; most major central banks target about 2% a year. Too much inflation erodes savings, distorts decisions and forces central banks to raise interest rates sharply. Too little, or falling prices (deflation), can trap an economy in weak growth. For traders, inflation is one of the most important macro drivers of bonds, currencies, stocks and commodities.

Measuring inflation#

inflation rate = (price index this year / price index last year) - 1

What causes inflation#

The 2021 to 2023 inflation surge combined several causes: strong demand from fiscal stimulus, supply chain disruptions after the pandemic and energy price shocks after Russia invaded Ukraine. US CPI inflation peaked at 9.1% year over year in June 2022, the highest since 1981.

How central banks respond#

Central banks fight high inflation mainly by raising interest rates, which slows borrowing, spending and hiring. The Federal Reserve raised its policy rate from near zero in early 2022 to a range of 5.25% to 5.50% by July 2023, one of the fastest tightening cycles in decades. See The Federal Reserve and the FOMC and Interest Rates.

Inflation and markets#

Real returns#

real return ≈ nominal return - inflation

A 5% return with 3% inflation is a real return of about 2%. Investors care about real returns because they measure changes in purchasing power. See Measuring Returns and CAGR.

Deflation#

Falling prices sound good but can be harmful: consumers delay purchases, debts become heavier in real terms and economic activity can slow. Japan struggled with mild deflation for much of the period from the late 1990s to the 2010s.

Frequently asked questions#

What is inflation?#

The general rise in prices across an economy over time, which reduces the purchasing power of money.

Why do central banks target 2% inflation?#

A low, stable rate gives room to cut rates in downturns, reduces the risk of deflation and allows for measurement bias, without the costs of high inflation.

How does inflation affect stocks and bonds?#

Rising inflation usually hurts nominal bonds and can lower stock valuations, especially when it forces central banks to raise rates sharply.

Next, learn the main inflation reports in CPI and PCE.