Inflation and forex trading (part one)

The inflation rate is one of the most commonly observed variables by forex traders, because of its strong impact on the value of the domestic currency and the exchange rates.

The effects of inflation on the forex market are higher in cases where the inflation rate is very high than in cases where it is very low. A very low inflation rate often does not cause major jolts in the markets, while an extremely high inflation rate and, in particular, cases of hyperinflation, usually causes strong effects on currencies.

At the macroeconomic level, it should be remembered that inflation, which is defined as a generalised increase in prices of an economy, is closely related to interest rates, and that both these two variables have an impact on the foreign exchange market. However, it is only interest rates that have a direct effect on currencies, as they make domestic currency-denominated financial assets more or less lucrative – and therefore desirable – for investors. Inflation, on the other hand, has more a signalling effect on the markets, as it anticipates the central bank’s future interest rate moves, which are necessary to stabilise price movements. This is done through the monetary policy management.

According to mainstream economic theory, based on the Keynesian model, the setting of low interest rates by the central bank stimulates consumer spending and, as a result, economic growth. Consequently, interest rates have a positive impact on the value of the domestic currency. If consumer spending increases to the point where demand exceeds supply, the consequence is higher prices. To prevent that the excessive price increases discourage demand, the central bank can intervene by hiking interest rates. Moreover, low interest rates do not usually provide an incentive for foreign investment in a country. High rates, on the contrary, attract foreign investment, and thus increase a country’s demand for currency. Increased demand for a currency makes that currency appreciate.

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