The forex market is where foreign currencies are traded. Therefore, the exchange rates of currencies play a crucial role in what is happening in the forex market. While there are a myriad of factors that directly and indirectly influence these exchange rates, inflation is one major factor that can single‑handedly sway the forex market. Hence, it is important to know what inflation is and how it influences the forex market.
| Inflation generally has a negative effect in the Forex market |
So, let us start with the very basic question – What is Inflation?
Simply put, inflation is the average price change of prices of goods and services in a country over a given period of time. It shows a decrease in the currency’s buying power. For instance, what you could buy 10 years ago for $100, would now require a lot more than $100. This is the effect of inflation. The power of $100 has decreased 10 years later. Or in other words, the value of money has decreased.
An increased rate of inflation indicates that the prices of goods and services are rising fast whereas a decreased rate of inflation indicates that the prices are increasing only at a slower rate. A reasonable level of inflation is good for the growth of the economy. Inflation gives an idea about the current account balance of a country.
Inflation is measured mainly using two price index reports – Consumer Price Index (CPI) and Product Price Index (PPI). While CPI measures the cost of goods and services from the perspective of the consumers, PPI does the same from the perspective of the industries producing the goods and services. Out of these two indices, CPI is the indicator that is most frequently used by governments to calculate inflation. However, in order to get a more accurate measure of inflation, PPI reports are also assessed along with CPI reports. However, according to some experts, this way of measuring inflation may be a bit lagging.
Having understood what inflation is and how it is calculated, let us now discuss how it influences the foreign exchange market.
Inflation and Forex Market
There is a close connection between inflation and the forex market. The rate of inflation in a country determines the value of its currency as well as its exchange rate with other currencies.
| Higher the inflation, weaker the currency |
If the rate of inflation is high, it means that the cost of consumer goods in that country’s economy is very high. As a result, there will be a reduced number of foreign consumers for these goods. That would mean less foreign currency in the economy. When there is less foreign currency, the trade balance of that country is adversely affected. When there is an unfavourable trade balance in a country, the demand for that currency will automatically go down. Low demand for the currency will push its value down. This will have an impact in the forex market.
Again, the central bank of every country will intervene in many ways depending on the status of inflation and this intervention will also have a corresponding influence in the forex market. For instance, when there is very high inflation, people will not be motivated to save money. Rather, they would look for opportunities to spend money on or buy assets before the value of their currency falls even further. So central banks will increase their interest rates to encourage people to save more. Now this increased rate will increase the demand for the bonds of that country. That would translate into increased demand for the currency of that country. When the demand for a country’s currency goes up, its value also goes up in the forex market.
The reverse happens when there is a decrease in inflation. Central banks will cut interest rates to encourage lending and thus pump more money into the economy. This will reduce the demand for the country’s bonds and thereby the demand for the currency. This will pull the value of currency down in the forex market.
The Bottom Line
The currency rates fluctuate depending on banks’ monetary policy. Therefore, a smart forex trader will always keep themselves abreast of the latest news releases. This will help prepare and prevent any surprise price fluctuations, which in turn will help maintain a consistent winning score in trades.