Price dynamics
The term inflation refers to a general increase of prices of goods and services over a sustained period of time. Conversely, we talk about deflation in case of falling prices.
Inflation, by far the most common situation, occurs when demand for goods tends to outstrip supply, or when more money is introduced in the economy (by printing it, by positive balance in the import/export currency flows, or other more complex market and monetary conditions).
A healthy economy typically has low values of inflation where investors can create business cases to provide a return superior to other forms of investment such as government bonds and obtain a reward for the borne risks. On the opposite, deflation is commonly associated with period of economic depression because people tend to delay spending and keep their cash as its value increases with time. The result is lower circulation of money, less sales and investment, thus creating unemployment and a self-sustaining downward spiral. Banks lose their primary source of income (i.e., lending money to investors) and need to close, with all the consequences that entails. Japan is an example of a country which suffered deflation in the 1990s and beyond.
For this reason, central banks use the monetary lever to provide stimulus when inflation tends to drop to zero or become negative (i.e., deflation): if interest rates are very low so are money markets returns, and this should prompt investors to put their money elsewhere and hopefully towards companies that could provide better returns.
Why then high inflation is negative? Many poor economies suffer from hyperinflation, why is that bad? Well, to start with, inflation, by our definition, destroys the real value of money. Money is supposed to be a means of exchange, but in these conditions it has lost that role and becomes virtually meaningless as its value can dramatically change in a single day.
Under such conditions, the most common defence for operators and people is to immediately convert any received cash into a foreign currency, thus creating a permanent loss of confidence and even legitimacy for the local currency. At a point where this foreign currency (typically the U.S. dollar, highly convertible) sometimes replaces the local one in practice.
Another defence, if we might call it as such, is to spend the money immediately because tomorrow it will buy much less. This drives extreme behaviours of consumption.
The inflation rate of a country strongly affects the currency exchange value against foreign currencies. Prices of same goods tend to level out or be equivalent across countries (the principle of arbitrage), less custom duties. Therefore, exchange rates tend to follow, with some margins and time delays, price variations of goods and services. The classic example is the Big Mac Index: being McDonald almost everywhere and offering products considered to be affordable by large chunks of the population in the world, the price of the Big Mac is a good indicator of relative currency strength and its distance from its fair value.
How is inflation measured?
Measuring the inflation rate is not easy, but necessary and critical for political and monetary policies. We talked about price increase for goods and services, but what is the most representative set of such goods and services for a country with complex and varied standards of living? Besides, goods and service evolve and it is hard to compare privé evolution overtime; computers, mobile phones and communication prices fall in this fast evolving category where tracking is particularly hard.
Typically each country has a dedicated official organism of Statistics taking care of measuring prices and defining the best average reflecting such conflicting demands. What falls in and out such sets of goods taken as reference also changes over time and is subject to debate.
In the end, the official resulting inflation rate intervenes in the definition by governments and other business representatives of salary raise in both public and private sectors. It is obvious that governments tend to like low inflation rate numbers.
The Economist collects information from various sources and provides inflation rates, among other economic indicators, for many countries.
Real and nominal terms
Finally, some clarifications of terms sometimes used by economists. We refer, for instance, to nominal rate of returns when we mean the gross return, whilst ‘real’ is the nominal rate of return less the inflation rate. For instance, we say that our investment has returned 10% this year in nominal terms (face value). However, if the inflation during the same period was 3%, our real rate of return is 7% only.
The economist Irving Fisher has formalised it this way:
(1 + nominal rate) = (1 + real rate) x (1 + inflation rate)
Hence, make sure you mean the same thing when discussing investment opportunities, especially if considering various countries and currencies, with your financial consultant or provider.