Depending on a country’s inflation rate, and the resultant interest rate, the value of the country’s currency and the rates of foreign exchange it has with other countries’ currencies can be significantly affected.
Inflation, on the other hand, is only one element among many that influence a country’s currency rate when taken together.
We take a close look at how the inflation and interest rate work in tandem to affect the current price for traders.
The relationship between inflation and the interest rate
Inflation data and interest rate announcements are two of the most significant events for any forex trader to keep an eye on during the day. A central bank’s mandate includes ensuring that inflation remains stable, but it’s fair to say that this can be a difficult task to do.
The rise in inflation is beneficial in the long run. Because any capital that is not earning returns will depreciate in value, it is a positive indicator of an expanding economy and a compelling motivation to invest or spend money.
However, if inflation climbs to an excessive level – particularly when wages have not climbed in tandem – commodities can become prohibitively expensive. Hyperinflation is the extreme end of this spectrum, and it can escalate to the point where a currency becomes utterly worthless.
As a result, the majority of central banks are entrusted with maintaining an inflation rate of approximately 2-3 percent per annum. The interest rate is the most effective method of maintaining stable inflation.
How interest rates affect inflation
Raising or reducing the basic interest rate for an economy should have the effect of either increasing or decreasing savings or increasing consumption.
Both of these will have a wide range of knock-on effects on the economy, and they will ultimately result in either higher or lower inflation, depending on how they are implemented.
When the interest rate goes up
Increases in the base interest rate increase the cost of borrowing for commercial banks, which is a negative feedback loop. This motivates them to raise their own interest rates, resulting in better returns on savings for firms and consumers, while borrowing becomes more expensive.
This has the effect of reducing consumer spending in an economy, leading economic growth to stall. Money supply tightens as a result of more cash being retained in bank accounts and less being spent, resulting in a decrease in demand for commodities.
Lower demand for commodities should result in lower prices for those goods, hence cutting inflation.
When the interest rate goes down
The cost of borrowing for commercial banks is reduced as a result of the reduction in the base interest rate. As a result, they are more likely to cut their own interest rates.
After that, both businesses and consumers will discover that interest rates on savings accounts and loans are extremely low. As a result, borrowing and spending are appealing, while saving is discouraged.
As a result, the economy expands, the money supply expands, and consumer spending on goods and services increases as well. Inflation should rise as a result of increased demand for goods, which should result in higher prices.
Despite this, it is always important to keep in mind that economics is rarely straightforward; a variety of other factors might come into play when interest rates are raised or dropped. A central bank may also encounter periods of low inflation and be unable to cut interest rates.
The effect of the inflation rate on Forex trading
Depending on a country’s inflation rate, the value of the country’s currency and the rates of foreign exchange it has with other countries’ currencies can be significantly affected. Inflation is only one element among many that influence a country’s currency rate when taken together.
A currency’s value and foreign exchange rate are more likely to be affected by inflation than they are to be affected by a currency’s value and foreign exchange rate being affected by inflation.
However, while a country’s exchange rate with other countries will not necessarily be favourable if its inflation rate is exceptionally low, a country’s exchange rate with other countries will almost certainly be adverse if its inflation rate is excessively high.
The real exchange rate
Currency exchange rates can be either “nominal,” which means that the rate is determined by the market, primarily on the world foreign exchange market, or “real,” which means that the rate has been corrected for inflation and is the corrected nominal rate.
Real exchange rates, on the other hand, must be calculated because nominal exchange rates may be easily obtained by checking forex market pricing.
Consider the following scenario: If a country has an inflation rate of 5 percent and the country of the counter currency has an inflation rate of 2 percent, the currency of the first country would have a real exchange rate that is 3 percent higher than the currency of the second country, with the nominal rate remaining the same.
There are two groups of definitions for the real exchange rate, the first of which has to do with purchasing power parity and the second of which does not.
Real exchange rates are defined by the nominal exchange rate modified by the ratio of the foreign price level to domestic price level for a specific good or a basket of goods, according to the purchasing power parity definition.
In addition to tradable and non-tradable items, the real exchange rate can be defined in terms of their value in dollars.
According to this definition, the relative prices of tradable and non-tradable items are combined to form an indicator of the country’s level of competitiveness in international commerce and trade in services.
Based on this definition, the cost differential between the two countries is precisely proportional to the relative price structures in both economies.
The effective exchange rate
This rate, which is also known as the Trade Weighted Exchange Rate, is composed of a multilateral exchange rate that is a weighted average of exchange rates of both local and foreign currencies, with the weight for each country corresponding to its part of global trade.
It assesses the average price of a domestic good relative to the average price of goods produced by its foreign trading partners, with each country’s proportion of trade serving as the weighting factor for that country.
How inflation and interest affect currency prices for traders
As a crucial component of its economic management policy, central banks often fight inflation by raising or lowering interest rates, as already noted.
As a result, they may decide to boost the level of short-term interest rates in order to keep inflation under control. In addition, they may cut these same rates in order to fight deflationary tendencies and stimulate the economy by making it simpler to borrow money from the financial institutions.
As a result, central banks have an indirect impact on wholesale and consumer prices in this way. These, in turn, have an impact on the value of the country’s currency, and, as a result, on the degree of economic activity in the country in question.
Given how inflation impacts interest rates when an economic number indicative of inflationary trends is issued that indicates an increase in inflation, the currency of the country that released the number will often appreciate in value. I
Interest rates would be increased higher in order to combat the inflationary trend, which would lead this effect to manifest itself.
In contrast, if the statistic reflects a fall in inflation, this will likely put downward pressure on the currency since interest rates will be adjusted lower as a result of the decrease in inflation.
Considerations that traders should keep in mind
When it comes down to it, the perceived desirability of holding a country’s money is what ultimately determines the value and exchange rate of that country’s currency.
Those perceptions are influenced by a variety of economic factors, including the stability of a country’s leadership and the strength of its economy.
The safety of having cash assets in a foreign currency is the first consideration for investors when it comes to currency, before any potential returns.
In the event that a country is perceived as politically or economically unstable, or if there is any significant possibility of a sudden devaluation or other change in the value of the country’s currency, investors are more likely to shy away from the currency and are less likely to hold it for long periods of time or in large amounts of money.
Aside from the important perception of security associated with a country’s currency, a variety of other factors, such as inflation, can have an impact on the exchange rate of a currency.
An individual currency’s value is influenced by several factors, including the pace of economic growth in a country, its balance of trade (which shows the degree of demand for a country’s goods and services), interest rates, and the level of a country’s debt.
Investors keep track of a country’s most important economic data in order to assist determine its exchange rate. Which of the numerous possible influences on exchange rates predominates is subject to change and is dependent on the situation at the time.