Inflation is an essential economic indicator. It is scrutinised by central banks and financial markets, heavily influencing their decision-making.
It also plays a pivotal role in the value of currencies. Exchange rates react to both inflation data and interest rate changes influenced by inflation.
In this article, we’ll be looking into the relationship between inflation and interest rates, why this is important and how it affects currency markets.
Inflation and interest rates
Inflation can be defined as the overall rise in price of goods and services. It’s used to quantify the change in a country’s cost of living. When the price of goods is high, inflation goes up. The Consumer Price Index (CPI) is used by the UK and the US to measure inflation.
Interest rates are set by central banks – such as the Bank of England (BoE), Federal Reserve (Fed) and European Central Bank (ECB). They refer to the amount you pay back on loans and how much you’ll be paid to save with a bank.
Inflation and interest rates have an inverse relationship. If interest rates are high, people get more for their money when they save in a bank.
As a result, people save more and spend less. People are also less likely to take out loans as they are more expensive. This means purchases of goods like houses drop due to poor value mortgages.
If people are spending less money, the demand for goods and services goes down. As such, businesses take action to entice people into spending. Usually, this means dropping prices. When prices drop, inflation goes down.
On the contrary, when interest rates are low, people can afford to borrow more money and are rewarded less for saving in the bank. So, people decide to spend their money instead. More loans are taken out and consumer spending on larger goods, like homes, increases.
And, as demand for spending increases, businesses can put their prices back up. This brings the cycle back to the beginning as inflation starts to build once again.
Read: Why is inflation rising in the UK?
Why raise interest rates?
The challenge for central banks is to determine the optimum time to increase and decrease interest rates to benefit the economy.
Reducing interest rates accelerates economic growth. Consumer spending increases which boosts the economy, but inflation increases too. Central banks eventually need to raise rates to stop inflation from getting out of control. If they didn’t, prices would become too high, purchasing power would decrease and savings would deplete.
Increasing interest rates slows economic growth. But, despite weighing on the economy, raising rates is necessary to control inflation.
Central banks look to raise interest rates at a point when the economy is doing well. Hopefully, the benefits of low interest rates will have lifted the economy. Now, as inflation is rising, rates can be increased, and the economy will manage the slowdown.
How do inflation and interest rates affect currency markets?
Inflation and interest rates are key to the performance of currency markets. And they get involved in a multitude of ways.
Perhaps the most notable is when interest rates are high, the value of a currency tends to increase. This is because investors get a better return on their investments, so favour countries that offer better rates. This is known as hot money flows.
In the UK, it works like this:
- The Bank of England increases interest rates
- Savings accounts, bonds, and other investments now give stronger returns
- Hot money flows occur as investors are attracted to the higher rates
- Demand for the pound goes up
- The value of the pound increases
However, this is not always the case. Investors also choose to move their money into healthy economies. A strong, stable economy can make their investments less risky.
Sometimes, central banks raise interest rates when the economy is weak. This happens when inflation is soaring, and measures need to be taken to slow the surge – regardless of the economy’s condition.
Investors evaluate whether a rate hike is due to a healthy economy or exclusively to tame inflation. If they assume the latter, increasing rates may not lift the value of a currency.
The real interest rate
Sometimes countries have high inflation rates and high interest rates. When this happens, investors look at something called the real interest rate. The real interest rate compares a country’s nominal interest rate (what the central bank sets) with its inflation rate. The difference between the two is known as the real interest rate.
For example, let’s say:
- The United Kingdom has an interest rate of 5% and an inflation rate of 3%. The real interest rate is 2%.
- The United States has an interest rate of 6% and an inflation rate of 5%. The real interest rate is 1%.
The United States has a higher nominal interest rate (6%) compared to the United Kingdom (5%). But, because of its higher inflation rate, the real interest rate is better in the United Kingdom. This may make the United Kingdom more lucrative for investors and improve the strength of the pound.
The reason they do this is because, while interest rates are a boost for a currency, high inflation has the opposite effect,
When inflation is high, goods become more expensive. Goods from a nation with high inflation are less competitive compared to a country with lower inflation – where things are cheaper. Demand falls as the goods from that country become less attractive. As a result, the value of that nation’s currency may decrease.
What is an example of how inflation has impacted the currency markets?
Between 2021 and 2024, central banks tangled with inflation, leading to volatile currency markets.
Post-pandemic inflation
A combination of Covid-19, war in Ukraine and a global energy crisis sent inflation soaring to astronomic levels in many major economies.
Central banks responded to the rise in prices differently, which had conflicting effects on currencies.
The ECB was reluctant to raise interest rates, dismissing inflation as ‘transitory’, which weighed heavily on the euro. It fell to 12-month lows against the dollar and 22-month lows against the pound in November 2021.
On the other hand, the Fed raised US interest rates more quickly, helping the dollar to outperform its rival currencies. In the latter stages of 2021, it reached 12-month highs against the pound and 18-month highs against the euro.
UK inflation in 2024
After two years of small, frequent rake hikes and steady inflation decline, the BoE cut interest rates in August and November 2024 to give the economy a boost.
The August announcement saw the pound fall against the dollar by 0.78% with the November decision resulting in a 1.46% drop.
However, on 18 December 2024, CPI data for November showed a rise in UK inflation for consecutive months for the first time since autumn 2022. The announcement caused the pound to plunge by 1.12% against the dollar on the day of the release.
Markets typically respond in one of two ways when inflation rises. Either, the nation’s currency strengthens as investors anticipate interest rate hikes on the horizon. Or, it weakens as that currency’s purchasing power decreases with it seen as less valuable on the market.
With the UK economy in desperate need of a lift, the BoE may have to continue with rate cuts despite increasing inflation.
If the economy struggles to rebound, the UK may be at risk of entering a period of stagflation – an economic term relating to the combination of slow growth, rising inflation and high unemployment.
With a bleak outlook on the UK economy, investors may have fled the pound in fear of further negative data to come.
Making international payments
From reading this article, you’ll know how much of a part inflation plays in influencing currency markets. Keeping track of inflation, and central bank announcements, can be tiresome and confusing. Missing crucial information could cause markets to move and lose you money.
At Privalgo, we can help you protect your budget from currency fluctuations following inflation and interest rate announcements. Our risk management solutions can help you lock in favourable rates of exchange regardless of whether currency markets move.
Get in touch with our Currency Specialists today to find out how we can help you budget effectively and protect your profits.
Book a chat with a Currency Specialist10 FAQs about inflation and exchange rates
Below are 10 frequently asked questions about the role inflation plays in influencing exchange rates. Some of the questions use content from this article to answer the questions.
How does inflation influence exchange rates?
Inflation directly impacts exchange rates by affecting a currency’s purchasing power. Higher inflation typically weakens a currency as goods become more expensive, reducing competitiveness and demand. Conversely, low inflation can strengthen a currency, especially when paired with high interest rates.
Why do central banks raise interest rates during inflation?
Central banks raise interest rates to control inflation. Higher rates encourage saving overspending, which reduces demand for goods and services. Lower demand can slow price increases, helping to bring inflation down over time.
What is the relationship between interest rates and currency value?
Generally, when interest rates rise, a country’s currency strengthens. This is because higher interest rates offer better returns on savings and investments, attracting foreign capital and increasing demand for the currency.
What is the real interest rate and why does it matter to currency markets?
The real interest rate is the nominal interest rate minus inflation. Investors look at real interest rates to determine the actual value of their returns. A higher real rate is more attractive, potentially increasing demand for a country’s currency.
What happened to the pound during UK inflation in 2024?
In 2024, the Bank of England cut interest rates to stimulate the economy. When inflation unexpectedly rose in November and December, the pound weakened significantly against the dollar as investor confidence fell.
How does investor sentiment affect exchange rates during inflation?
Investor sentiment plays a big role. If markets believe a central bank is handling inflation effectively, the currency may strengthen. But if inflation rises while economic growth stalls, confidence drops, and the currency often depreciates.
Can inflation lead to a stronger currency?
Yes, in some cases. If inflation is rising but the central bank is expected to raise interest rates in response, investor speculation can drive up demand for the currency in anticipation of better returns, temporarily strengthening it.
What are hot money flows and how do they impact exchange rates?
Hot money flows refer to capital moving quickly across borders to benefit from higher interest rates. If a country raises rates, it may attract foreign investors seeking returns, which increases demand for its currency and raises its value.
What role does the Consumer Price Index (CPI) play in currency markets?
CPI measures inflation by tracking changes in the cost of goods and services. Forex markets monitor CPI data closely; a surprise rise or drop in inflation can lead to sharp currency movements as traders adjust for potential interest rate changes.
How can businesses protect against exchange rate risk during inflation?
Businesses can protect against volatility by using FX tools like forward contracts or market orders. These strategies help lock in exchange rates ahead of time, shielding international payments from unexpected currency movements caused by inflation.
This article is for information purposes only and should not be considered as financial advice.
