Trading: What’s the Relationship between Inflation, Interest Rates, GDP and Unemployment?

10 January 2023 - 11:44

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Let’s talk about one of the most important macroeconomic reports to anticipate market movers.

Trading: What's the Relationship between Inflation, Interest Rates, GDP and Unemployment?

In this historical phase we find ourselves facing a situation in which the macroeconomic components are nothing short of fundamental in the choice of investment and trading decisions, both in the short and long term, as has not happened for years. In the long term, it is difficult to understand how the data could evolve, while in the short term, the difficulty lies in establishing whether we are in a market moment in which it is possible to exploit the volatility thanks to the release of the data, beyond the their outcome.

In essence, the fundamental macroeconomic components concerning central bank interest rates and inflation rates which act as guide for the performance of the economy, have once again played a central role in the investment choices of operators. In this historical moment we must therefore give greater weight to some macroeconomic dynamics which had been neglected for some time and which have been literally overshadowed by the actions of central banks aimed at monetary expansion and the increase in the monetary base immediately following the Lehman Brothers crisis and the 2012 European debt crisis.

At an economic level, we immediately saw the impact of inflation on spending, while the central banks started a path of monetary tightening which should lead to a slowdown in the growth of inflation. But how will the situation evolve? What will happen when interest rates begin to have a direct impact on the economy even before lowering the inflation rate? This macroeconomic situation implies the analysis of these components, which are essential in order not to remain unprepared over the next few months and thus avoid nasty surprises for the management of one’s investment portfolio and one’s trading account.

Inflation and interest rates

Inflation represents the level of price growth, a figure that is used by central banks to establish whether an economy has a healthy growth rate and above all useful for establishing how much liquidity a central bank must inject/remove from the financial system. The central banks therefore have an inflation target, a target which, if exceeded, sees the central banks operate in a restrictive sense precisely to avoid a further increase in prices, in the event instead of a sharp drop in inflation, the bank central will have to implement an expansive policy to feed the economy and circulate liquidity again aimed at increasing consumption and positive expectations on investments.

Essentially inflation is a telltale sign of how the economy is performing and in times of economic shock, both positive and negative, central banks are forced to act. In the current historical moment in which we see very high inflation levels, central banks are implementing restrictive economic policies to lower this inflation and they do it through the interest rate.

The interest rate represents the cost of borrowing for banks to borrow money from the central bank. An increase in the cost of money leads commercial banks to ask for less money, or rather, to pay more for the money needed for loans, mortgages and loans, therefore an increase in the interest rate for banks also leads to an increase in the cost of credit for consumers who will be more inclined to wait for better conditions to make purchases such as a home (through a mortgage) or, in even more blatant cases, to avoid consumer loans aimed at removing some "whims".

This leads to a controlled decrease in consumption which actually leads to a drop in inflation as the general demand for consumer goods decreases and to a contraction of GDP within the economic areas. In this historical moment we are perfectly in this situation in which interest rates are rising, prices are slowly starting to fall and consumption will tend to fall over time.

In this context we must also consider the fact that an increase in interest rates takes a long time to see its realization within the economy, therefore we still have several months ahead in which we could see further decreases in the inflation rate. Having made this analysis of the current situation, the duty of the investor and trader is to ask themselves what will be the direct consequence of this situation and what changes will it lead to within the economy?

GDP and unemployment

A direct consequence of this scenario is precisely that relating to a decrease in consumption, resulting precisely from the increase in the cost of credit. If consumption decreases, GDP also decreases as a lower demand for goods leads companies to have to go through periods of suffering in which there is no demand for goods that covers supply, therefore companies will have to produce less or better yet lower prices to see increased demand. In this context we therefore have the productive sector which finds itself with two difficulties: the first is that relating to the cost of credit, i.e. the lines of credit opened with banking institutions will be more expensive and therefore the risk of closure is high for some small businesses and medium cut.

Those with small capitalization or those who have lagged behind the changes taking place in the economy run the risk of having to close or limit their workforce. Precisely the limitation of the workforce leads to an increase in what is defined as the "unemployment rate", another fundamental element for central banks, in addition to inflation, to establish the state of health and the direction that a specific economy.

An increase in the unemployment rate is the direct consequence of a restrictive policy accompanied by high inflation, well beyond the targets set by the central banks. This scenario therefore seems, at least in theory, inevitable and therefore starting to consider the unemployment rate as the next market mover is a decision that could be important in investment choices

How to use these elements in investments?

The analysis of the macro components, their direct consequences on the market and their trend helps us to understand where we are in terms of the economic cycle. Right now we’re in a situation where we’re heading into a recession and the worst place of an economy is when, in addition to having a sharp decline in GDP, we have a rising unemployment rate. Theoretically, the low point of an economy is reached when there is the coexistence of a high interest rate, low inflation, declining GDP and high unemployment rate.

Right now we have interest rates still rising, inflation still high, GDP levels falling slightly and unemployment rates at low levels, so we still have a relatively good picture currently but it could worsen over the next few months. This type of analysis is therefore very useful for understanding what could be the best time to invest and for trying to build a long-term portfolio that rewards risk, while for short-term traders it is a very useful in trying to understand what could be the moments in which real "traps" appear in short-term movements.

Original article published on Italy 2023-01-10 08:56:00. Original title: Trading: quale relazione tra inflazione, tassi di Interesse, Pil e disoccupazione?

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