Inflation

What does inflation mean?

Inflation is the loss of purchasing power of money – in other words, a general and sustained rise in the price level of goods and services. With an annual inflation rate of 5%, a basket of goods that cost $100 a year ago now costs $105, so the same $100 buys less. Inflation generally arises when the supply of goods and services falls short of total demand; rising costs, for example for energy, can also drive prices up.

Measurement and forms of inflation

Inflation is usually measured with a consumer price index (CPI), which tracks the prices of a representative basket of goods and services. In the US, the CPI is published by the Bureau of Labor Statistics, while the Fed's inflation target refers to the PCE price index; the euro area uses the Harmonised Index of Consumer Prices (HICP). Many central banks aim for inflation of around 2% over the medium term.

Depending on its pace, a distinction is made between creeping, moderate and galloping inflation. The boundaries are not fixed: creeping inflation means prices rise slowly, moderate inflation is noticeably higher but still manageable, and galloping inflation reaches double-digit annual rates or more and quickly erodes confidence in money. The extreme case is hyperinflation, as in Germany in 1923. The opposite of inflation is deflation.

Why inflation matters for traders

Inflation figures are among the most market-moving releases because they directly influence the interest rate decisions of central banks. A higher-than-expected reading makes a high interest rate policy more likely, which tends to support the currency but can weigh on bonds and stock indices. Lower-than-expected inflation tends to have the opposite effect. Traders also watch "core" inflation, which excludes volatile food and energy prices.