While exchange rates are subject to myriad factors in intraday trading—market sentiment, breaking economic news, 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.
To ensure relative pricing stability, central banking authorities actively manage the amount of money in circulation at any given time. This is accomplished through manipulating interest rates, managing interbank lending practices and engaging in open market operations. When central banks take action, the currency markets and broader forex marketplace reflect the shift in policy.
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 price levels locally that are affected by inflation. It is generally agreed that this theory mostly holds true over the long run.
However, economists have found that currency trends are prone to suffer short-term distortions because of trade, investment barriers, local taxation, and other factors such as commodity pricing. For instance, commodity dollars such as the Canadian dollar (CAD) are sensitive to the pricing swings of raw materials. In the case of the CAD, exchange rates are positively correlated with the price of crude oil and natural gas.
As a result of this relationship, one can expect the exchange rate forecasts of countries with higher inflation rates to be depressed in comparison to their peers. Conversely, the 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
For several reasons, inflation in the economies of currencies being traded is an important factor to consider.
- First, it affects the relative value of those monies internationally on the foreign currency exchange market (forex).
- Second, it can determine future policy adjustments by governments and central banks.
In either case, each of these market drivers has the potential to create new or disrupt existing currency trends.
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. Subsequently, items such as the U.S. dollar exchange rate or pricing of exotic, cross or major forex pairs can be dramatically impacted.
Through the 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. The manipulation of interest rates—both up and down—is a primary market driver of the world's major currencies.
It's important to remember that no currency is exempt from volatility stemming from interest rates. Regardless if you are trading the British pound sterling (GBP), euro (EUR) or Japanese yen (JPY), interest rates will be a key market underpinning. To account for interest rate fluctuations, be sure to monitor statements from central banks such as the Bank of Japan (BoJ), Bank of England (BoE) and the U.S. Federal Reserve (Fed).
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. Known as interest rate parity, this theory posits that real interest rates (interest rates less inflation) across borders tend to move toward equilibrium. Accordingly, currencies in economies with higher interest rates tend to weaken over time against those privy to lower rates. As a result, interest rate parity can serve as a significant converter of wealth between different nations and regions.
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.
The interest rate parity dynamic is the crux of a forex carry trade, which pairs a currency with low interest rates to one with higher rates. Historically, the Australian dollar (AUD) and New Zealand dollar (NZD) have been ideal targets for carry trades due to their elevated lending rates. One common carry trade is the AUD/USD, which pits the Australian dollar against the US dollar.
Currency traders, then, hope to predict future currency trends 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.
Inflation is a periodic increase in consumer prices, which undermines the purchasing power of a domestic currency. Economists measure inflationary pressures in many fashions including PPI and CPI. In order to minimise the phenomenon's impact, central banking authorities actively manage interest rates, interbank lending practices and the aggregate money supply.
No currency is immune from the impact of inflation. Regardless if you're trading the USD, GBP, JPY, EUR, Australian dollar or Canadian dollar, staying abreast of inflationary pressures and central bank actions is a key to success.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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