How Higher Inflation Impacts Currency Exchange Rates

How Higher Inflation Impacts Currency Exchange Rates
April 19, 2022 Market Traders Institute

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One thing that’s on top of every investor’s mind these days is the rise in inflation we’re witnessing all around. The last reading showed us that inflation in the U.S. rose to its highest level in 40 years. What’s more problematic is it has picked up pace in recent months.

In March 2022, inflation surged to its fastest rate since 1981. Food and energy prices skyrocketed year-on-year, and the consumer price index (CPI) hit 8.5%. Here’s a look:

 

Because rising inflation could lead to many problems for the economy as well as consumers, the Fed wants to tame it. And it is planning to do so by raising interest rates.

If the Fed does that, the rate at which it lends funds to other banks increases. This means low borrowings from these banks and the consumers, and it ultimately leads to less money in circulation in the market. That’s one of the simple ways in which a central bank can try to bring down inflation rates.

But it’s not as easy-peasy as it sounds. There are many factors involved, and tinkering any one of them could have a cascading effect on the others.

So, to make it simpler, let’s focus on the effects of inflation on exchange rates.

To do that I’m going to explain why the U.S. dollar (USD) has been strengthening since 2021.

The USD has been in a downtrend since the start of the pandemic in 2020. But that has changed since the end of January 2021.

We saw a U-turn in the market and the USD broke its downtrend line to the upside, as can be seen in the chart below…

This begs the question: While the equity markets went on breaking new highs every other day since 2021, why did the USD witness new highs and lows?

The simple answer to that is ‘inflation.’ As inflation rose, the dollar started strengthening.

The CPI has been climbing since 2021…

 

This bears importance if you are a Forex trader. 

One of the core concepts of Forex trading is understanding that inflation will affect interest rates, and interest rate expectations will affect exchange rates.

So…

Higher Inflation = Higher Interest Rates = Stronger Currency

And this is evident from what we’ve been seeing in the last couple of months. As the CPI started to move higher, the USD has been in an uptrend.

That tells us that as a trader, you have to look at fundamental inflation announcements in the economic calendar to plan your trades for potential profits.

A higher inflation reading will mean bullish sentiment for the market, while a lower reading will mean bearish sentiment.

Take the GBP basket for instance…

Suppose the market expects to see the inflation figure to come out at 0.5% for the UK tomorrow. However, the actual reading comes out higher than that. In this case, I would expect the GBP basket to strengthen during that trading session.

All because of the same formula we saw above.

So, that’s a simple way to know which way the exchange rates are most likely to move during fundamental inflation announcements. And place your Forex trades accordingly to cash in some potential profits.

Tian Kriek, Senior Currency Strategist at Market Traders Institute, has also recorded a short video on this concept a while back, which you can Watch Here.

For more Forex strategies and trades, you can join Tian’s Analyst On Demand Trading Room.

Every week, within the trading room, Tian will take you through real market conditions and help teach you the keys to being a consistent trader.  You can access it by clicking here >>

 

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