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 Bernanke, 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.


By ABE COFNAS