Should we forget about inflation?

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Investors are now paying more attention to budget deficit, public debt and stimulus measures. Nevertheless, Central Banks continue to emphasize as key macroeconomic benchmarks of monetary policy inflation rate.

Inflationary mechanisms

In order to understand the mechanism of inflationary processes impact on the exchange rate The following simple example can be given: in one of the neighboring countries the prices for goods and services have increased by 1.5-2 times. It became more profitable for its residents to buy products in the neighboring country, but for this purpose it is necessary to purchase its currency first. The increase in demand for the neighboring country's currency leads to an increase in its exchange rate against the national monetary unit.

Nevertheless, in modern conditions, a one-step price increase is more of a result than a cause. For example, in Belarus last year there were several devaluations of the national currencyAs a result, its exchange rate against the Russian ruble fell almost three times. As a result, residents of Smolensk, Bryansk and other neighboring regions found it profitable to buy Belarusian goods, as they turned out to be several times cheaper in terms of rubles. The increase in demand provoked a rise in prices.

Naturally, devaluation is by no means the main reason for the development of inflationary processes. As a rule, the increase in the cost of goods is caused by excessive money supply in circulation. Quite a long time ago, within the framework of the quantitative theory of money, the Fisher formula was developed, which tied together various macroeconomic indicators.

MQ=PV

where M is the value of the money supply,
Q — скорость обращения денег,
P — динамика цен на товары и услуги,
V is the volume of goods and services created by the national economy.

When analyzing this formula, it becomes clear that the absence of price growth is possible only if the dynamics of real GDP will correspond to the increase in money supply and velocity of money circulation.

Causes and Consequences

In the case of the Belarusian economy, overly inflated programs of preferential lending against the background of wage increases to fulfill election promises led to a significant excess of the left side of the equation over real GDP. As a result, prices rose.

At present, the Central Banks of the leading countries are pursuing a stimulating monetary policy with the aim of resuming economic growth. It provides for an increase in liquidity of the banking system, which should be aimed at issuing loans to the real sector of the economy. It is planned that enterprises will have access to relatively cheap loans and will increase production volumes at their expense.

However, to implement this mechanism, firstly, time is needed, and secondly, not all banks are ready to use the provided resources for their intended purpose. This is due to the increasing credit risks of both entire states and individual economic entities.

In addition, it is necessary to understand the resources with which Central Banks make new loans, or buy back the bonds. In this case, it is an issue that increases the volume of money supply. Further lending leads to an acceleration of the velocity of money circulation. At the same time, the positive impact of the policy of "quantitative easing" on GDP will be felt only in the medium or long term. At present, in order to fulfill the conditions of macroeconomic equilibrium, the following should come into play inflation.

It should be noted that in an economic recession inflation growth can be perceived as a positive factor for the national currency. The fact is that the increase in prices is a sign that consumption, the volume of which is a significant part of GDP, is growing. At the same time, the state should pursue a strict anti-monopoly policy to prevent commodity producers from raising prices as a result of their collusion.

Thus, when studying the impact of inflation on the exchange rate, there are quite a lot of contradictions. On the one hand, its excessive growth forces the Central Bank to apply strict measures to limit the money supply, on the other hand, deflation may indicate a consumption crisis and limit economic growth. Thus, the recent growth of the consumer price index in China was perceived by the market as evidence that the Central Bank of the Celestial Empire will stop reducing interest rates in order to stimulate the economy under the pressure of inflationary processes. As a result, the Australian dollar fell for a while due to the close foreign economic relations between the two countries and gold, due to the fact that China is one of the main consumers of precious metal.

At the same time, the development of deflationary processes against the backdrop of the problems caused by the need to eliminate the consequences of the environmental crisis contributed to a significant slowdown of the Japanese economy.

Moderate inflation

Thus, the optimal option looks like moderate inflation. Each Central Bank has its own target benchmarks and investors should keep an eye on how they will be met.

For example, the Federal Reserve uses the Consumer Price Index, excluding food and energy prices, as a target.

At the same time, the Fed's ability to regulate it is limited, as the main instrument used in this case (we are talking about raising the refinancing rate) is frozen until 2014. Consequently, other methods will have to be used: issuing new loans or restricting lending. All this will not contribute to economic growth, but it may support the US dollar exchange rate, as it will limit investors' risk appetite.

Conversely, a reduction in inflation will provide an incentive for another round of "quantitative easing", which will return market participants' interest in risky assets.

Thus, it should be understood the mechanism of inflation impact on the exchange rate at different stages of the economic cycle, as well as to assess its impact on medium- and long-term market trends. In addition, I recommend studying inflationary processes taking into account the economic development of a particular country. For example, do you think there are differences in the impact of an increase in price indexes on the Russian ruble and the British pound?

As stated in one of the definitions, "inflation is a complex socio-economic process...". It is really complex and ambiguous, and we will definitely return to its further study in the process of fundamental knowledge of the market.