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. As currency markets react to inflation data, exchange rates change.
So, how does inflation affect exchange rates?
Inflation can affect economies on both a national and international scale. Shipping costs, for example, simultaneously affect businesses from all over the world.
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.
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 when they save in banks with high interest rates. As a result, investors pour their money into 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 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 prefer to move their money into healthy economies. A strong, stable economy makes their investments less risky and more profitable.
Sometimes interest rates go up 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 have the desired effect on 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 works in the opposite way.
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 become less attractive. As a result, the value of a currency decreases.
What is an example of how inflation has impacted the currency markets?
Central banks tangled with inflation in 2021. Prices soared and continued on a worrying trajectory in the US, UK and EU.
But policymakers feared increasing interest rates to tame the wild inflation would ruin post-pandemic economic recovery. This led to much debate. And currency markets felt the full force.
On one side, you had Europe’s approach. The ECB remained firm throughout 2021 that inflation was merely a symptom of global supply chain issues. Christine Lagarde (President of the ECB) was adamant that Europe wouldn’t raise rates until 2023 at the earliest.
This stifled the euro, particularly in the latter stages of 2021. In November, it hit 12-month lows against the dollar and 22-month lows against the pound.
In contrast, the dollar enjoyed a strong November as US inflation data for October came in at 30-year highs (6.2%). But, despite prices going through the roof, US consumer spending was up by 1.3%.
This gave the Fed plenty of justification to hint at an interest rate hike, helping the dollar to outperform its rival currencies. In the latter stages of the year, it reached 12-month highs against the pound and 18-month highs against the euro.
An interesting challenge for central banks is how to respond to new variants of Covid-19. We mentioned earlier that raising interest rates is often a boon for currencies. However, increasing interest rates during lockdowns is a recipe for disaster.
Making international payments
From reading this article, you’ll know how much of a part inflation plays in the currency market world. Keeping track of inflation, and the thoughts of central banks, can be tiresome and confusing. And what’s more, missing crucial information could cause markets to move and lose you money.
Fortunately, at Privalgo, we provide state-of-the-art payment solutions to protect your international transfers from FX volatility. And on top of extra protection, our top-tier rates mean that your payments will maintain value throughout the exchange.
To find out more about how we can help, book a free chat with a Privalgo Currency Specialist today.Book a chat with a Currency Specialist