Inflation and exchange rates

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On the Forex market, inflation is an economic indicator that is highly monitored by traders. The inflation rate is one of the most important determinants of exchange rate developments even if other elements are taken into account.

Definition of inflation

Before addressing the mechanism that links exchange rates and inflation in Forex, it is important to define inflation and where it comes from.

Inflation is a general increase in prices. It is measured by the consumer price index. To calculate inflation within a country or geographical area, the percentage change in the index between 2 given periods is calculated. This is how we obtain the monthly and annual inflation rate.

Inflation originates from money creation. This money creation is measured by the level of the money supply, which is constantly increasing. But an increase in the money supply does not necessarily mean that there is inflation. What leads to inflation is a faster increase in the money supply in relation to the wealth produced (measured with GDP). Effectively, this generates pressure of demand on a supply that does not increase at the same rate. The consumer price index then increases, generating inflation.

The close relationship between inflation and interest rates

The inflation rate is highly monitored by central banks. They examine inflation to direct their monetary policy and set their policy interest rates. Each central bank generally sets itself an inflation threshold that it does not want to exceed and seeks to avoid deflation (often synonymous with economic recession).

In this way, if the inflation rate is too high, the central bank raises interest rates to contain inflation and avoid economic overheating. Money creation is then slowed down, which drives inflation down.

On the other hand, if we are on the verge of deflation, the central bank lowers interest rates to stimulate the economy by making money cheaper to borrow (which increases money creation and therefore generates inflation).

If inflation is moderate, the central bank sets its interest rates according to the level of inflation and also according to the economic growth rate (GDP). Of course, many other factors are also taken into account by central banks, but this is to simplify things.

Inflation therefore has an impact on the level of interest rates, but the opposite is also true.

The effects of inflation on the exchange rate

The level of inflation has a direct impact on the exchange rate between two currencies on several levels:

- Purchasing power parity: Purchasing power parity attempts to compare the different purchasing powers of each country according to the general price level (and not the exchange rate). This makes it possible to determine the country with the most expensive cost of living. Changes in purchasing power parity (and therefore inflation) affect the exchange rate. If inflation is the same in both countries, the exchange rate does not change. If it is higher in one country than in the other, this is when inflation affects the exchange rate. The currency with the higher inflation rate then loses value and depreciates, while the currency with the lower inflation rate appreciates on the Forex market.

- Interest rates: Too high inflation pushes interest rates up, which has the effect of depreciating the currency (less remunerative) on Forex. On the other hand, inflation that is too low (or deflation) pushes interest rates down, which has the effect of appreciating the currency on the Forex market. However, inflation has a much more frequent negative effect than a positive one. A high rate of inflation is likely to have a negative impact on the exchange rate, while low inflation is far from a guarantee of an increase in the exchange rate.

But be careful, an inflation figure alone does not mean anything. What central banks are monitoring is changes in the inflation rate. If it continues to grow, there is a risk of rising interest rates. Conversely, if the inflation rate is in a downward trend, there is a risk of falling rates. But central banks always relate the level of inflation to the country's economic growth rate. Changes in interest rates depends on monetary policy, but most of the time, central banks refuse to sacrifice economic growth, especially in times of crisis.

It should also be noted that the impact of inflation on the exchange rate is theoretical. Indeed, many other factors are taken into account in determining the exchange rate.

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