It’s been several years since the world’s leading economies have been beset by inflationary pressures. Now, as every nation attempts to pull out of the COVID pandemic’s effects, many national governments are expecting to see inflation take hold during the last quarters of 2021. How will rising price levels (the definition of inflation) affect currency markets?
No one can say for sure, but if history is any indication, it’s not inflation alone that makes a difference for a country’s currency. The key concept to remember is that relative inflationary levels have more of influence on currency strength. Of equal importance is what causes prices to go up. An inflated consumer price index is usually the result of at least five different factors, some more relevant than others.
The essential lesson for foreign exchange traders is which of those five are likely to come into play and impact any given nation’s prices. Beginning with the current situation in the UK, here’s a short overview of the how inflated prices are affecting international currency markets.
The UK Example
The UK was one of the first developed nations to take decisive action in the face of the COVID pandemic. Now that restrictions are easing up, and the UK economy is getting back to normal, nationwide demand is expected to outpace production in multiple sectors. Government ministers are preparing for a significant rise in general price levels as inflation-related data are heating up.
What does this mean for the strength of the nation’s currency, the pound sterling? Because higher domestic prices tend to weaken whatever form of money a country uses, foreign-exchange dealers and investors are getting ready for a drop in the strength of the pound against nations whose prices are not set to rise as much.
What Forex Traders Should Know
Every forex trader should know the five core factors that influence the strength of a nation’s currency.
First off, excessive consumer demand tends to pull prices upward, while manufacturing cost rises are usually said to push price levels higher.
Additionally, when the national debt rises, or when the money supply increases, inflationary pressures come into existence. The fifth factor is a bit more complex, as it involves the national currency’s exchange rate. As a general rule, a poor exchange rate leads to higher overall prices.
It’s easy to become over-focused on prices, although they do play a central role in forex strategies for casual and professional traders. But, there’s more to life than price levels, and dozens of other things that lead to a currency’s strength or weakness. What are they? The main ones include the following:
- Current Account Deficits: When a national government is running a deficit in its current accounts, the overall effect is usually a negative one on the relative value and demand for its denominated money.
- Interest Rates: Rising interest rates are a double-edged sword. When it comes to the world of forex, it’s usually safe to assume that whenever a country’s interest rate rises, so will its currency’s strength. One advantage of interest rates is that they’re easy to measure and publicly available at any moment.
- Recessions: Recessions are almost the flip-side of interest rates, at least in terms of foreign exchange markets. That’s because whenever a national economy is beset with a recession, the next thing that happens is that interest rates fall. After that, the currency’s value also begins to decrease. That’s why interest rates are often seen as a clear predictor of many other parts of an economic community.
- Speculation: Speculation in currency markets is hard to assess, but it does play a role. When people demand something, for reasons real or imagined, the price and value of that thing usually rises. So, if China’s yuan is in high demand based on rumors or simple expectations, it will enjoy a bump in value.
- Political Stability: This factor, unlike some of the others, make simple, logical sense. Would you want to park your investment capital in a place undergoing an armed revolution or war? That’s why political stability is usually something that adds to a given currency’s strength. Nations with long histories of regional wars and domestic political upheaval are, of course, not going to attract investors of any kind.
The main thing to remember is that an inflation rate alone is not a reliable predictor of a currency’s strength. In foreign exchange trading, all factors must be considered relative to one another. If, for example, the U.S. inflation rate is significantly higher than Japan’s rate, then the Japanese yen will be relatively stronger than the dollar, assuming all other factors are equal (which they never are).