Inflation, Tightening and Easing

The target

Most major central banks target 2 percent consumer price inflation. Above it they lean towards higher rates; below it, towards lower. The gap between actual inflation and the target, and whether the gap is closing or widening, is the frame through which every inflation release is read. Core inflation, which strips out food and energy, is watched more closely than the headline because it is less volatile.

Tightening cycles

A sequence of rate rises. Currencies usually strengthen through the early and middle stages as the market prices each step. Towards the end, when the bank signals it is done, the currency often weakens even though rates are at their highest, because the market has begun pricing the cuts to come. The peak of rates is rarely the peak of the currency.

Easing cycles

A sequence of cuts, usually in response to weak growth or inflation falling below target. Currencies weaken into and through the early cuts and often stabilise before the last, for the mirror-image reason. Emergency easing during a crisis is different: the dollar can strengthen even as the Fed cuts, because in a crisis everyone wants dollars.

The same number, different reactions

An inflation print of 3 percent is bullish for a currency when the bank is expected to raise rates and the market feared inflation might fall. It is bearish when the bank has said it will look through inflation and the market expected 3.5 percent. The number is only meaningful against the expectation and against the bank's current stance, which is why the next lessons cover both.

Key takeaways

• Central banks target about 2 percent inflation; core inflation is the closely watched measure.
• Tightening strengthens a currency until the end of the cycle is priced; easing does the reverse.
• In a crisis the dollar can strengthen despite cuts.
• An inflation print means nothing without the expectation and the policy stance.