In our strategy articles we have emphasized how important it is to find balance between fundamental analysis and technical analysis. The former makes more reference to macroeconomics, while the latter refers more to a merely technical aspect, namely the graphs and their interpretation. In this article we want to summarize some terms that you often hear but may not fully understand yet: recession, inflation, deflation, stagnation, stagflation. Knowing these well is very important not only in learning, but also in decision-making when you want to seize a statement on the fly that could affect market prices. If, for example, Draghi comes up with new data on deflation, it is necessary to understand what it is, and then act accordingly, if that data can affect a particular security, such as a currency pair.
Indeed, macroeconomic data often has an impact on currency pairs, since they depend on the value of individual currencies which in turn represent the well-being of any given economy. Therefore, one can easily understand how a healthy economy has a stronger currency than a recessionary economy.
It should be noted that when discussing a currency and the economy of the reference country, we can refer both to a single country (e.g., US dollar), and to a community of countries (e.g., Europe for the Euro). The difference between these two types lies in the fact that while a negative situation of a single state greatly affects its currency, in a community the trend of a single state influences the trend of the same currency in a more diluted way. For example, if Italy is in recession, its benchmark equity index will be hit, while the Euro (which includes more countries) will see more diluted effects. If Italy is in a recession, the Euro can count on other countries (take this purely as an example, without any reference to real data).
Let’s proceed now with the definition of these different situations in which an economy can be found.
A recession means a situation in an economy in which production levels are lower than those that could be obtained using all the productive factors available in a complete and efficient manner. More precisely, there is talk of recession when negative GDP growth (Gross Domestic Product) occurs for two consecutive quarters in an economic cycle with a duration of between 6 and 18 months. In the US, however, there is talk of recession when real GDP decreases, again for two consecutive quarters. In any case, the first definition, more commonly recognized, applies above all.
What recession implies: a recession is obviously a negative factor, which negatively affects the economy and can lead to a depreciation of the currency, especially if this situation continues over time. If we consider a currency pair, we must consider the fact that it is a relationship of two, so if both economies of the currency countries are in recession, the gap is reduced or could proceed in the same way.
By inflation we mean a prolonged increase in the average price level. It takes into consideration what can be defined as long term, even if it is now also based on monthly data. The increase in inflation generates a decline in the purchasing power of the currency and therefore causes a decline in demand in general. Since prices are higher, less goods and services can be bought than in a situation where prices are lower, so inflation is what most affects consumers. When inflation is caused by the rise in commodity prices, it is called stagflation, which in this period practically does not exist, especially for oil.
What inflation implies: the issue is more complex than a recession. Inflation can be considered both from a negative point of view and from a positive point of view. If a price increase is combined with steady purchasing power, it means that the economy of a given country is strong, healthy and therefore also has a strong currency (especially in the case of “single” country). However, even a strong country can have export problems if it offers very high prices, as they would have to deal with a competition that offers lower prices.
On the other hand, if decreased purchasing power is combined with inflation, then there is an unequivocal symptom of an economy in difficulty.
Deflation is defined as the opposite of inflation. In fact, deflation is a fall in prices, usually caused by the reduction in credit availability. As you can understand, if on the one hand it is a positive situation for the consumer, on the other it creates a negative spiral for the profits of companies that risk a crisis, closure, layoffs, unemployment and so on. For example, think of certain countries where you can “buy everything at a very low price”. If you go to deepen the discourse, you will discover that the country does not fare very well economically.
Stagnation means an economic situation in which there is calm in terms of GDP and per capita income. This is not a recession since there is no decline, but simply a situation of persistence and non-growth.
Stagflation is a term that mixes Stagnation and Inflation, usually in the presence of high unemployment. This is a complex situation in which governments can run their heads for several years. You think that stagflation first appeared in the 1960s and was previously thought to be impossible by major economists. The existence of stagflation also undermined the famous Keynes and his “general theory of occupation, interest and currency”. To oust him was a certain Milton Friedman who started so-called “Monetarism”.
History of the economy aside, this new situation put Western governments to the test because they had to fight something they had never faced. This is a stalemate in which central banks should reduce the amount of money circulating to contain the demand for goods and services, which, however, would not favour economic growth and therefore there would be no return of unemployment.