Inflation
The rate at which the general level of prices rises over time, reducing what a unit of currency can buy. Central banks set interest rates largely to keep it near target.
Inflation is the percentage change in the overall price level, usually measured year on year with a consumer price index (CPI) or a related measure such as the euro area's HICP or the US PCE price index.
Targets
Most major central banks aim for low, stable inflation. The US Federal Reserve, the European Central Bank and the Bank of England all target 2%, though they use different measures: the Fed focuses on PCE inflation, the ECB on HICP and the BoE on CPI.
Why it matters for currencies
- Through interest rates: high or rising inflation tends to lead central banks to raise rates or keep them high, which usually supports a currency in the short to medium term.
- Through purchasing power: over long periods, a currency with persistently higher inflation tends to lose value against one with lower inflation, an idea known as purchasing power parity.
These two effects can point in opposite directions, which is why the market reaction to an inflation number depends on what it implies for policy.
Worked example
Illustratively, a basket costs 100 euros in October last year and 103 euros this October. Annual inflation is 3%. A saver holding cash earning 2% has lost about 1% in purchasing power. If the central bank expected inflation to fall to 2.5%, a 3% reading may push markets to price higher rates.
Headline and core
Headline inflation includes energy and food; core excludes them to show the underlying trend. Both are watched closely.
See how economic data moves forex and what moves currency prices.
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