Understanding Inflation & Forex

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Most people, even without a background in economics or finance know that inflation means that the value of a currency is going down.

Broadly speaking, this is translatable in some sense to the currency markets. If one currency has higher inflation than another, it’s reasonable to think that its value will decrease when compared to the other. This would be a basic source of fundamental analysis for trading.

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However, financial markets are more complicated than that. And while an economic understanding of inflation is more than useful for traders, the impact of inflation and its data on currency markets is a little more sophisticated. So let’s take a little deeper dive into inflation and how it applies to forex.

What About Deflation?

Negative inflation, or deflation, is generally not something seen in modern fiat currencies. It’s typically only an issue when there are significant economic problems in a given economy. When the next recession eventually rolls around, we can talk about the effects of deflation. For now, it’s the different rates of inflation that inform traders and market reaction when tracking inflation data releases.

Something to keep in mind first is that the Consumer Price Index is not the same as inflation.  Even though, for practical reasons, CPI is generally used as the measure of inflation. Second, we should note that different countries use different methodologies to determine their CPI and gauge of inflation.

Consequently, inflation rates are not necessarily comparable directly between countries. If Country A has an inflation rate of, say 2.3% and Country B has an inflation rate of, say 2.4%, it doesn’t necessarily mean that Country B’s currency is losing value faster than Country A’s.

Variations in how we calculate inflation can account for that difference. And it might even by the reverse: that Country A’s currency gets stronger.

The Market’s Expectations Change Everything

The next factor is that everyone has access to inflation data. So if you have a case where two economies have diverging inflation rates, the market is going to account for that. It will actually “price in” the change before it even happens.

Let’s say Country A’s inflation rate is 1%, and Country B’s is 2%. You’d think the latter’s currency is losing value at twice the rate of the former’s. But if economists, analysts, and traders saw this, they would sell Country B’s currency ahead of the data to take advantage of the differential. So, when it comes out officially, the currency pair doesn’t move. The market, through its expectations, had already accounted for the difference.

This is why it’s important to keep track of market expectations before the release of data. After all, everyone is always trying to get ahead of the market move.

The Central Banks

But before traders and analysts, usually, central banks know about inflation moves since they have access to more data. Central banks can control the value of the currency directly.

Anticipating a potential increase in inflation, they can take corrective measures like buying certain amounts of their own currency to increase demand. This will then keep the currency from dropping below certain levels. Sometimes this intervention is communicated, sometimes it’s not.

Then there is the combination of expectations and the central bank. As inflation rises, traders increasingly expect that central banks will intervene to keep the inflation rate from going too high. This is mainly because all central banks are mandated to maintain currency stability.

Intervention strengthens the currency, and this is why you can have these counterintuitive moves in the market where inflation comes in higher than expected, and the currency gets stronger.

Multiplicity of factors

The bottom line is that what drives currency fluctuations are small changes in the relative value, and inflation is intimately related to the value of the currency. This is why it’s often the most important event on the economic calendar, and it’s still fundamentally true that differences in inflation rates change how the currencies relate to each other.

However, each data release is subject to the impact of many factors at the same time. This is why it’s always a good idea to check out the previews available on the Orbex website to get a clearer picture of how inflation at any given time might influence currencies.

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