Dynamics of Modern Financial Markets: Understanding Value and Inflation

Current Market Conditions

This is the Euro and the US dollar. Dynamics of Modern Financial Markets The Euro and the US dollar that trades 1837 on September the 10th, 2020, on the ECB decision. The ECB did not announce the interest rate yet, and the press conference is still in front of us, but it is a very suitable time to discuss inflation and the value of money because the ECB is under tremendous pressure lately. Why? Because inflation dropped significantly.

Understanding Inflation Levels Dynamics of Modern Financial Markets

Now let me share here two things. Dynamics of Modern Financial Markets number one is, let’s say this is the zero level. What does it mean, zero level? When inflation reaches zero, every Central Bank in the world, but absolutely every Central Bank in the world, at least in the developed world, has an inflation target that goes around 2%. Now why is that 2%? 2% is the equivalent of price stability in the Central Banking world. Price stability means that inflation at 2% is far away from the zero level, so not to threaten deflation.

The Danger of Deflation Dynamics of Modern Financial Markets

When inflation drops below the zero level, this is called deflation. Deflation represents one of the most difficult economic phenomena the Central Bank faces, and there is literally no known solution for it. If you don’t believe me, just check at what Bank of Japan struggled with for the last two or even three decades, and even now it fails to bring inflation to the target.

When inflation moves below zero, it causes deflation. In plain English, what does it mean? Deflation triggers a vicious cycle. For instance, assume that you want to buy a smartphone, and you have the money available. You go to the store to buy it, and you see that you were willing to pay for it $500, and the cost is $450. You might say, “Well, I might wait a couple of months to see what the price will be on Black Friday.”

The Impact of Postponed Purchases Dynamics of Modern Financial Markets

Then on Black Friday, you will see it is $380, and you say, “Well, I will wait until Christmas,” and now Christmas, it’s $350. So you postpone the decision. The money is not moving; the velocity of money in the economy declines, and that means that inventories are rising at the wholesalers, factories are not producing anymore or at the same level, and so on and so forth. People will lose their jobs, unemployment benefits will be on the rise, and the government will have more expenses. The account deficit will increase, as you can see, triggering a vicious circle.

Central Bank Targets and Hyperinflation

This deflationary level, therefore, the consensus among central banks is that a 2% level is far away from the zero level but not too far for other negative inflation perspectives like hyperinflation. What does it mean, hyperinflation? If you have inflation at 20%, that’s called hyperinflation. Hyperinflation usually forms in emerging markets, frontier markets—think of Turkey, Venezuela, Russia, Eastern Europe after communism, and so on—where people do not trust the central bank or the central bank lost its credibility in keeping the value of money.

When the value of money is lost, people turn to alternative investments to protect their savings, like gold, jewels, physical gold, or physical assets—houses, cars, something that keeps the value when the money loses value.

Disinflation and Its Effects

Another important concept in terms of the value of money is dropping inflation. Let’s assume that inflation drops from 22%, this is called disinflation. When inflation still drops but remains in positive territory, that’s called disinflation. To some extent, disinflation is a good thing in the sense that when it comes from higher levels towards the central bank’s target, it’s a good thing.

But when disinflation happens between two and zero, then that’s a problem, and it’s not a good thing anymore because the central bank will not favor this situation. So is the case with the ECB today, in the sense that the ECB or the core inflation in the Euro area is at a record low of 0.4%.

ECB’s Mandate and Market Pressure

Now, 0.4% is something that is far away from the ECB target of 2%. The ECB’s mandate or price stability mandate calls for keeping inflation or bringing inflation below but close to 2%. 0.4% is far away from the 2% level, and the recent Euro strength—this is the Euro US dollar jumping from 08 to 1.20 in less than three or four months—put further pressure on inflation to drop even more and threatens to break into the below zero level.

Central Bank Interventions

Therefore, the ECB or any central bank, as a matter of fact, will be forced to intervene. How does a central bank intervene? It cuts the interest rates, delivers quantitative easing, and uses other unconventional monetary policies, like TLTR, which are targeting long-term refinancing operations in order to provide stimulus and to stimulate businesses to borrow and expand their activity, and so on and so forth.

Conclusion

The value of money is very important for society as a whole, and the central bank is there to ensure that the money is not losing its value. 2% represents price stability and the target for a central bank. The problem is that in this game of inflation, central bank, fiat money, and population, there’s all about trust. If trust or credibility disappears, then you will have a problem in bringing inflation to target and in people believing that you are able to fulfill your mandate.

That’s the danger for the ECB, for instance. If the ECB or if the people fail to believe that the ECB is able to bring inflation to the target, inflation will keep dropping below the zero level, which will further put pressure on economic downturn, economic recession, unemployment, and so on and so forth.