In this article, learn how inflation rates connect to currencies, including:
- the relationship between Forex rates and inflation;
- how inflation rates can trigger volatility in the currency markets;
- what happens to a country’s currency when prices rise;
- and how interest rates are related to inflation and Forex.
Are you puzzled by the connections between inflation and currencies? You’re not the only one. Even experienced traders wish they had known about this macro-economic information before making certain trades that did not perform as expected, so it’s smart to learn about it as early as possible.
Inflation rates are like undercurrents and rip tides in the Forex market; you can’t see them, but they are definitely there. When annual inflation rates are normal – normal means around 2 percent growth per year – the undercurrents create financial tides that go in and out in a relatively predictable manner. Prices move within a given range and consumers know what to expect from their daily shopping or fuel expenses. This is the ideal scenario, the one that global central banks have in mind when they talk about price stability.
Price stability means that you know on average how many units of your country’s currency will be needed for basic goods and services. In the UK, consumers know how many GBP it will take for a gallon of petrol, for example. If the price for petrol shoots up overnight, the invisible current of inflation has just created a tsunami in the economy.
What happens to a currency when inflation rises?
When prices rise too quickly, the country’s currency loses much of its spending power. More units of money are needed to buy goods and services and carry out their financial plans, but where are these extra units to come from if salaries remain the same or grow too slowly to catch up?
Consumers might borrow more money or use more credit when they see the gap between their income and their expenses and try to pay the higher prices as best as they can. This actually feeds into the inflationary undercurrent, swelling it to the dangerous point of monetary inflation when a monetary unit might be worth less than the paper on which it’s printed.
At this point, the country’s currency becomes weaker versus other currencies, and is on the losing end of any exchange rates. Consumers who want to travel abroad will not be able to receive as much in exchange for their currency, and when buying from abroad, they would need more of their domestic currency to buy an item in the foreign currency.
Examples of the effects of runaway inflation can be seen in the Venezuelan Bolivar, where the International Monetary Fund expects the inflation rate to top one million percent and according to some reports, buying lunch could cost 250,000 Bolivars. This means that foreign currencies are strong compared to Bolivar and most transactions are carried out with foreign currencies.
Hopefully, the country’s central bank steps in before runaway inflation happens and raises interest rates so that consumers cut back on borrowing and spending and start saving because they will receive income from interest on their savings accounts. With monetary tightening, the inflation rate subsides as consumers reject high prices and price growth returns closer to 2 percent on an annual basis. Monetary tightening is a policy that preserves the value of a currency and strengthens it against foreign currencies. In this scenario, consumers who travel abroad receive an equal or even advantageous exchange rate for foreign currencies.
The relationship between Forex rates and inflation
How does all this relate to Forex trading? In a Forex trade made by a consumer, one currency is traded for another. The base currency (your domestic currency) is exchanged for the counter currency (foreign currency). This could look like: 1 GBP (domestic base currency) equals 1.17 EUR (foreign counter currency) and is a straightforward exchange of value at a rate given by banks or exchange rate agencies. In this scenario, the consumer owns the currency after making the exchange. A similar trade could be made at the institutional level by a bank, hedge fund or a central bank, of course these trades scale up by millions of currency units.
Forex trading can also be carried out with financial instruments called Contracts for Difference (CFDs). This is trading with derivatives, so-called because the contracts are derived from the underlying currency assets and mirror the actual movements in the Forex markets. In this type of trading, a trader doesn’t own the underlying currency, instead the objective is to make a return on the difference in price between the opening position and the closing position.
When inflation rises too quickly and currency values fluctuate, it can dramatically affect these price differences, causing volatility and unpredictability. Unless you’re aware of the effects of inflation on a currency’s value, you may assume that prices will be within an expected range when that is far from reality. Experienced traders know it’s important to exercise caution and have risk management strategies in place, including but not limited to:
- Stop losses
- Hedging strategies
- Careful monitoring of your trades
- Awareness and research of macro-economic conditions
- Understanding that economic conditions affect currency values
Before making straightforward currency exchanges or starting to trade CFDs on currencies during periods of high inflation or other macro-economic disturbances, we recommend learning more and taking our free Forex 101 course.
In addition, you could gain some experience on Admirals Demo Account before moving to a live account.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.