Understanding inflation in trading
You’ve probably seen asset prices move after new inflation data is released. But do you know what inflation is and why it causes such volatility in financial markets? The meaning of inflation goes beyond the everyday complaint that ‘everything is more expensive’. It affects much more than household budgets — from a country’s currency value to a company’s profitability. That’s why ignoring inflation when trading is like sailing through rough waters without a compass.
Here’s a deep dive into what inflation means, what causes it, and — most importantly — how it can shape your trading strategies.
Inflation eats into your wealth
Think of it this way – if a basket of groceries cost you $100 last year and $105 this year, that’s a 5% inflation rate. This means each unit of your currency now buys fewer goods and services. Inflation is not just a problem for individuals. People buying fewer goods means companies face less demand. This may cause some companies to lay off employees, making the situation worse. In this way, inflation can shake up economic stability.
Many ways of calculating inflation
How does a country calculate and announce what its inflation rate is? Economists rely on several key metrics to come up with this rate. The most widely used is the consumer price index or CPI inflation. It measures the average change in the prices that urban consumers had to pay for a set basket of goods and services. This basket includes everything, like food, rent, transport and medical care. It’s a comprehensive container of our daily expenses.
Another important way to calculate inflation is using the producer price index (PPI). This measures the average change in the price received by companies for their products.
Central banks like the Federal Reserve, Bank of Japan and European Central Bank monitor different types of inflation to make monetary policy decisions. They change their interest rates to ease or ignite inflation.
If you’re a trader, you need to analyse the impact of inflation on your chosen assets. Learn more about the markets and what moves different assets.
Factors that influence inflation
Inflation arises from a confluence of factors, broadly categorised into two main types. The first is called demand-pull inflation. This happens when the total demand in an economy is more than the aggregate supply. This usually happens when there is strong economic growth and high employment.
The other type is known as cost-push inflation. This is caused by an increase in the cost of producing goods and services. It could be due to rising raw material prices, higher wages or disruptions in the global supply chains. For instance, a sudden surge in crude oil prices can lead to higher transport costs for carrying raw materials. This can lead to higher prices for various goods.
Central banks adjust interest rates to stimulate or cool down economic activity. Lower interest rates encourage borrowing and spending, leading to demand-pull inflation, while higher rates can curb inflation by making borrowing more expensive.
Plus, unforeseen events like natural disasters or geopolitical conflicts can significantly impact supply chains, leading to cost-push inflation.
The relationship between inflation and forex trading
Inflation is a key consideration for forex traders since it directly impacts currency values. Higher inflation generally leads to a depreciation of the domestic currency, relative to currencies of countries with lower inflation rates.
Conversely, a country with a relatively stable or lower inflation rate might see its currency appreciate, as it becomes more attractive for foreign investment. Forex traders meticulously check what the inflation rates associated with their chosen forex pair are, along with other economic indicators, to predict currency movements.
For instance, if a central bank raises interest rates, it can strengthen the national currency. This was observed in January 2025, when the Bank of Japan raised its short-term policy rate to 0.5%, the highest in 17 years. Following the announcement, USD/JPY jumped by about 0.5% to $155.32.
How inflation affects the stock market
The stock market’s reaction to inflation often depends on the type and severity of inflation. Inflation can erode corporate earnings by increasing the cost of raw materials, labour and transportation. This can compress profit margins and, consequently, hurt stock valuations. However, some companies, particularly those with strong pricing power, can pass on increased costs to consumers, thereby mitigating the negative effects.
Different sectors respond to inflationary pressures in varying ways. Defensive sectors like consumer staples and utilities, which provide essential goods and services, tend to be more resilient as demand remains relatively stable. On the other hand, growth stocks, which rely heavily on future earnings projections, can be more vulnerable to inflation as higher interest rates (a common response to inflation) could hurt such earnings.
Understanding the essentials of trading and factors that move your preferred assets is the first step to finetuning your trading strategy.
Inflation’s role in trading strategies
Given its pervasive influence, inflation plays a significant role in shaping trading strategies. For instance, rising inflation might lead a forex trader to short a currency, or a stock trader to rotate their portfolio towards inflation-resistant assets or sectors that historically perform well during inflationary periods.
Understanding the cyclical nature of inflation is important for traders to adjust their exposure and leverage, adapting their approach based on whether inflationary pressures are building or subsiding.
Practical ways to adapt to inflation as a trader
Here are some pointers on incorporating inflation data into your strategy.
Monitoring economic reports
Regularly follow an economic calendar for releases of CPI, PPI and other inflation-related data. Also, stay updated on central bank announcements regarding monetary policy changes.
Adjusting trading approaches based on inflationary cycles
During periods of high inflation, experienced traders tend to increase portfolio allocations to inflation-hedging assets. Forex traders tend to focus on countries with stable inflation or those where central banks are aggressively tackling inflation. Meanwhile, stock traders shift towards companies with strong balance sheets and pricing power.
Diversification
A portfolio that is diversified across different asset classes and geographies reduces your reliance on any single inflation measure such as CPI or inflation rate and cushions its impact on specific assets.
To put these strategies into practice without risking real capital, open a demo account to practice inflation-based trading strategies.