The Role of Inflation

Inflation is in many ways the elusive enemy of central banks throughout the world.

Much progress has been made over the decades. In the period of 1973 through 1987, inflation levels in industrialized countries were near the 7.5 percent range. A decade later, in 1989, inflation levels ranged at the much lower level of 3 percent. Today, all you have to do is read the central banks’ public documents to realize that their major mission is to contain inflation. Many central banks, in fact, announce inflation targets. In fact, Bernard Breanne, the successor to Alan Greenspan, has favored formal inflation targeting for the U.S. Federal Reserve, and this is a significant change from Greenspan’s famous verbal ambiguity in his communications strategy.

Central banks around the world monitor inflation and raise interest rates to try to slow down inflation. Central banks often include in their statements accompanying interest rate decisions that they will be vigilant over potential risks of inflation. This is commonly known as being an inflation “hawk.” Whenever inflation is feared to be lingering in the economy, traders interpret this fear as raising the probability that interest rates will increase.

A fear of lingering inflation tends to generate in the market the anticipation of higher rates, and therefore works to support the buying of a currency. That is also why strong retail prices tend to undermine bond prices. Bondholders fear increased rates because they reduce the attractiveness of the bonds they hold, and the market lowers the prices of the bonds in order to equalize the yield of the old bonds with the new interest rates.

Inflation is the ever-present yet stealthy ghost that spooks the forex market and challenges central banks. It is particularly difficult to track. There is ongoing controversy.

Even among the best economists on how to measure and detect inflation, and as a result there are many data sets relating to inflation. Central banks all over the world are trying to get an accurate answer to the question of what is true core inflation.

This level of complexity in measuring inflation sets up the forex market for surprises when data comes along that inflation has not been contained. If central banks can’t be accurate in measuring inflation, why should an individual trader? Surprises can be expected.

For example, in December 2006, when inflation data rose the highest in 30 years, it provided a boost in the dollar value as more traders were betting that the Fed would not decrease rates, or might even increase rates.

Speaking of the challenge in interpreting monthly inflation numbers during his tenure on the Federal Reserve Board, former vice chairman Alan Blinder said, “The name of the game then was distinguishing the signal from the noise, which was often difficult.

The key question on my mind was typically: What part of each month’s observation on inflation is durable and what part is fleeting?” (Commentary on “Measuring Short-Run

Inflation for Central Bankers,” Federal Reserve Bank of St. Louis Review, May/June 1997).

The challenge to getting a true measure of inflation has also been a focus of recent activity in Britain. The Office of National Statistics is introducing a new inflation calculator that allows persons to calculate their own inflation measure! In other words, the other measures [such as the Retail Price Index (RPI), the Retail Price Index excluding Mortgage Payments (RPIX) and the Harmonized Index of Consumer Prices (HCIP)] are still in force, but there is recognition that inflation needs more measures for an accurate assessment.

This confusion and debate over how to detect inflation in Great Britain underscores the issue is an international one. The Monetary Policy Committee of the Bank of England (www.parliament.the-stationery-office.co.uk/pa/ld199899/ldselect/ldmon/96/9615.htm) offers more details on this subject.

The good news is that the forex trader doesn’t have to become a Ph.D in economics to follow inflation data. There are many key measures of inflation that are tracked. But you have to check the central bank web sites.