Inflation risks in the financial markets

What is inflation?

Since we have already defined this concept in an article, let’s recall it in a simpler way. Inflation is the speed at which a currency loses its value, and consequently causes the general rise in the prices of goods and services. It reduces the purchasing power of a currency.

Causes of inflation

The main cause of inflation is the increase of money in circulation. This regulation is done by the Central Banks of each country or region through quantitative easing (something we’ll leave for another article), which consists in injecting money into the economy by buying various financial assets.

There are 2 other important reasons that cause inflation

  • Demand inflation – An increase in the demand for products or services, and a steady supply can lead to an increase in prices. It usually happens in periods of a healthy economy, where money is more abundant and there is more demand. Or when there is actually little supply available.
  • Cost inflation – This type of inflation happens due to an increase in the cost of production of a good or product, and if there are no alternatives, the price of those goods and products increases to compensate. Let’s imagine oil: in case of general problems in its extraction or transportation, fuel prices would increase accordingly.

Risks to the financial market

At present, there is still no consensus on the danger of inflation to the economy in the near future, but the biggest concern for some investors is the amount of money that has been pumped into the economy by some central banks. This could lead to a considerable increase in inflation:

  1. It puts more money into circulation.
  2. Extremely rapid economic improvement can lead to a sharp increase in consumption.
  3. Since there is no supply to keep up with consumption the prices of products and services will consequently increase.
  4. Consequently, the increase or decrease of one currency against another will impact imports/exports of countries that would see this change in value as either positive or negative depending on this change.

To try to control a sharp increase in inflation, Central Banks may reduce the money in circulation and raise central interest rates to reduce the incentive for consumption of goods and products.

These attempts to adjust inflation may direct us to another major problem, which will be the effects on investor expectations. Concerns of this nature can lead to a decrease in risk appetite, consequently reducing investments and creating the environment for a new correction in the financial markets.

The biggest adversity that Central Banks face is not only to reach a specific inflation figure, because as a rule Central Banks target 2%, but to reach a constant inflation figure that provides the least possible impact on the economy.

Given all the associated risks, it remains to be seen whether Central Banks will succeed in this ambitious goal.

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