While exchange rates can be subject to myriad factors in intraday trading - from market sentiment, breaking economic news, and cross-border trade and investment flows - inflation and interest rate policy are often important indicators for exchange rate trends - they can help traders gain an idea of what is likely to be a profitable trade for foreign exchange positions taken over longer periods.
Inflation is commonly thought of as the pace at which prices increase in a given economy and determines the "worth" of money in relation to goods and services offered. If more money is perceived to be circulating at a given time, suppliers of goods and services typically react by adjusting their prices upward, meaning less can be purchased with a given unit of currency. Conversely, if the offer of money by consumers appears to be scarce, suppliers often react by lowering prices to attract buyers, meaning inflation will decelerate and money in that economy will gain relative value.
Purchasing Power Parity Theory
Under the theory of Purchasing Power Parity, the change in the exchange rate between two countries' currencies is determined by the change in their relative price levels locally that are affected by inflation. It is generally agreed that this theory mostly holds true over the long run, but economists have found that it can suffer distortions over the short term because of trade and investment barriers, local taxation, and other factors.
As a result of this relationship, one can expect the currencies of countries with higher inflation rates to weaken over time versus their peers, whereas currencies of countries with lower inflation rates tend to strengthen. In economies with weak production of local goods and services, the depreciation of the local currency can at times even be accelerated by the "pass-through effect" of importing foreign goods with relatively higher prices.
Measures Of Inflation
Inflation is normally measured by governments using groups of price levels for goods in varying sectors known as price indices. These include measures such as a producer price index (PPI), which measures wholesale inflation, and a consumer price index (CPI), which measures inflation for consumers. Governments and central banks frequently use these indices to help determine their economic measures through instruments such as inflation-targeting strategies.
Inflation in the economies of currencies being traded is an important factor to consider because it affects the relative value of those currencies internationally and because it can determine future policy adjustments by governments and central banks.
Through use of monetary policy, national central banks attempt to adjust their base interest rates and available banking money reserves to control the rate of lending by banks within their economies. The theory is that when there is more, or cheaper, money perceived to be available in the economy through bank loans and other types of credit, consumers and businesses will spend more, sellers of goods and services will adjust prices upward, and inflation can accelerate.
Conversely, when there is less, or more expensive, money available, consumers and businesses will restrict their spending, prices will fall, and inflation will decelerate. Thus, if central banks want to curb inflation, they will raise interest rates; and if they want to induce spending and economic activity, they will lower interest rates.
Interest Rate Parity
While directly related to inflation control policy, interest rates are also considered to have their own particular relevance for foreign exchange trading because of what is known as interest rate parity. This theory posits that the real interest rates (interest rates less inflation) across borders tend to move toward equilibrium, and that currencies in economies with higher interest rates tend to weaken over time.
However, where capital is allowed to move freely across borders, investors will seek to put their money in countries where they can get the highest returns. Thus, if one country has a higher interest rate than another, money will tend to flow to the country with the higher interest rate, causing that country's weaker currency to once again appreciate over time. When the currency has risen to an equilibrium price level where its cost is no longer offset by gains from its higher interest rate, it reaches interest rate parity and further investment flows from abroad come to a halt.
Currency traders, then, hope to predict future exchange rate movements by paying attention to the relative levels of inflation in the countries of their target currency pairs in addition to where each country is in its monetary policy cycle, and the size and pace of currency flows moving into and out of each country. While this can offer a potentially advantageous position, nothing is for certain and traders should do their due diligence when considering following this information.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…