Inflation refers to the general increase of prices in an economy which leads to a corresponding reduction in purchasing power over time.

There are three types of inflation: demand-pull inflation (when an increased supply of money and credit leads to greater demand), cost-push inflation (when the price of raw materials increases) and built-in inflation (where people generally expect prices to continue increasing). 

What are the different types of inflation and how is inflation caused? 

Inflation is a measurement of rising prices, which can affect all parts of society, including financial markets. Inflation can fall into three categories or types:
  • Demand-pull inflation: this type of inflation occurs when the supply of money (or credit) within a system increases. This creates a greater demand for goods and services. The demand increases faster than supply chains, which leads to an increase in prices.   
  • Cost-push inflation: this type of inflation occurs when the price of raw materials increases. This increases production costs and can reduce supply. If demand doesn’t change, the increased costs are passed on to consumers which reduces their spending power. 
  • Built-in inflation: this type of inflation occurs when people expect prices to continue increasing. Since a similar rate of increase in prices is expected, workers expect wages to increase in line with the rising cost of living. These two factors don’t always move in unison, but as one changes, the other must change. This creates a cycle of change, which is known as built-in inflation.

Many different factors can be drivers of inflation, and they can all fit into one of the above categories. Inflation leads to a decrease in purchasing power. Some of the most common causes of inflation include: 

  • Printing more money: when central banks print and issue more money, supply increases. This drives down the value of money already in the market which, in turn, reduces individual spending power. 
  • Devaluation: there are times when a legal tender can be deliberately devalued by a government/central bank. This can be done as part of an economic strategy (often to reduce a trade deficit).
  • Purchasing bonds: government bonds can be a way of getting more money into circulation. These bonds are issued by governments and purchased through banks on the secondary market. Bonds are, in essence, a type of loan. So, the process of buying bonds can loan new money into the market as reserve account credits. 

How is inflation measured? 

Banks and financial institutions measure inflation using a variety of methods, but the most common are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). At a basic level, these indices reflect the rising cost of everyday goods and services over time. 
The faster inflation rises, the greater its impact will be. This is why it’s useful to measure inflation in percentages. You can use an inflation calculator for this. However, the basic equation compares prices now to prices one year ago. 
For example, the Consumer Price Index (CPI) records the cost of 700 items people buy regularly. It’s possible to give this basket of 700 items a total cost. We can then compare that cost to last year’s total for the basket of items. 

So, let’s say the total cost in 2022 was $400. In 2023, the cost is $420. 

$420 − $400 = $20 difference between the two prices 

$20 / $400 = 0.05 X 100 = 5% 

The price increase from 2022 to 2023 is 5%. This means inflation is at 5%. You can use this percentage as a guide to the average price increase of goods and services. From this, you can start to assess how the current rate of inflation might impact the financial markets. 
As a more generic consumer example, let’s say the price of milk in 2013 was $2 per gallon. In 2023, the price per gallon could be $3. This price increase (50%) is a result of inflation. Now, let’s assume that the average wage didn’t increase by 50% between 2013 and 2023. That leaves us in a situation where people’s spending power is lower in 2023 than it was in 2013. 

This relationship between income, spending power and rising prices underpins inflation. In turn, inflation underpins the economic, political and societal dynamics of society.  

What does inflation mean for traders and their portfolios? 

Inflation is important for everyone to understand. From financial experts and traders to consumers, inflation has an impact on almost every part of society. One thing to note is that inflation is a natural part of an economy. Prices tend to increase over time. 

However, the times when inflation rises faster than usual tend to have the greatest impact on society and the financial markets. Therefore, traders looking to define inflation need to think specifically about how quickly consumer spending power is dropping in relation to prices. 

Metrics such as the Consumer Price Index (CPI) can affect the financial markets. For example, the stocks you’re trading can be affected by imports and exports. Rising inflation might matter in this scenario because it may cost a company more money to broker international deals, produce goods and carry out its services. Prohibitive costs could slow down production/sales and cause the company to lose money. This would negatively impact the company's share price. Understanding the link between inflation and business can help you make better decisions when you’re trading. 

It’s important to look at historical data and current reports when you’re assessing whether inflation is going to have a positive or negative impact on your portfolio. You should also look at why inflation is rising, because the reasons behind the increase could tell you how much of an impact it will have on financial markets. 

Take into account the type of inflation and how it might affect the instrument you are assessing. For example, built-in inflation might not be as impactful on the markets as cost-push inflation. You can build these types of assessments into your overall trading strategy each time you make trades.

Put this into Practice


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