The Forex Trading Course: A Self-Study Guide to Becoming a Successful Currency Trader, 2nd Edition

Chapter 2The Role of Inflation, Reflation, and Deflation

Inflation and its inverse, deflation, are fundamental forces in currency trading. Central banks are always concerned about managing inflation so it doesn't turn too high, into hyperinflation, nor too low, and into a deflation. It's interesting to note that at first blush the fear of deflation seems unreasonable. Isn't lower price a good thing? To a consumer, it would seem so. But to an economy it means there is less growth. Therefore, fear of deflation is a major concern. For central banks, monetary policy is a balancing act.

Containing inflation in the Western World has in many ways been achieved. In the period of 1973 through 1987, inflation levels in industrialized countries were near the 7.5 percent range. A decade later, in 1989, inflation levels ranged at the much lower level of 3 percent. Today, a reversal of expectations has occurred in the world of trading, where inflation growth, partly due to the financial collapse of 2008, is low.¹

Central banks around the world monitor inflation and raise interest rates to try to slow down inflation. Central banks often include in their statements accompanying interest rate decisions that they will be vigilant over potential risks of inflation. This is commonly known as being an inflation hawk. Whenever inflation is feared to be lingering in the economy, traders interpret this fear as raising the probability that interest rates will increase.

The expectation of inflation increasing ...