Inflation has long been a serious enemy to economic growth and the world’s central banks constantly try to keep inflation in check by adjusting monetary policy. Inflation can influence currency exchange rates considerably, and the perception of inflationary trends makes up one of the basic items affecting central bank monetary policy. In this article we will explore how inflation affects the forex market.
Inflation can perhaps be most basically described as what results when too many dollars start chasing too few goods. This represents an oversimplification of the issue, but it does give an idea of the nature of inflation, which generally signals not the increase in worth of goods, but the declining value of the paper money used to buy those goods.
Because inflation affects all levels of society and the totality of consumers in an economy, it makes up one of the most important economic indicators to central banks and forex traders alike. First some words on inflation and forex rates.
Inflation and forex rates
Currency exchange rates can be “nominal” meaning that the rate is set in the marketplace, primarily on the world foreign exchange market, or “real” meaning the corrected nominal rate, adjusted for inflation.
While nominal rates can be easily accessed by reviewing forex market pricing, real exchange rates must be computed.
For example, if a country has an inflation rate of 5% and the country of the counter currency has an inflation rate of 2%, the first country’s currency would have a real exchange rate 3% higher than the second country’s, with the nominal rate unchanged.
Real Exchange Rate Definitions
There are two groups of definitions for the real exchange rate, where the first has to do with purchasing power parity.
According to the purchasing power parity definition, the real exchange rate is defined by the nominal exchange rate adjusted by the ratio of the foreign price level to the domestic price level for a particular good or a basket of goods.
The other definition for the real exchange rate has to do with tradable and non tradable goods.
The way it is defined is by taking the relative prices of tradable and non tradable goods to make up an indicator of the country’s level of competitiveness in foreign trade.
The reasoning behind this definition is that the cost differential between the two countries is directly related to the relative price structures in both economies.
The Effective Exchange Rate
Also known as the Trade Weighted Exchange Rate, this rate consists of a multilateral exchange rate which is made up of a weighted average of exchange rates of both domestic and foreign currencies, with the weight for each country equal to its share in trade.
The effective exchange rate measures the average price of a domestic good relative to the price of goods of its foreign trading partners, using each country’s share of trade as the weighting for that country.
The following sections describe various methods of assessing inflation levels used by fundamental analysts with a focus on the U.S. economy, as well as the impact that inflation controls can have on the forex market.
Effects of Inflation in the Forex Market
Central banks tend to fight inflation by adjusting interest rates as a key part of their economic control policy. Read more on this here. As a result, they may raise the level of short term interest rates to contain inflation. In addition, they might lower these same rates to counteract deflationary tendencies and to stimulate the economy by making money easier to borrow. In this way, central banks indirectly affect wholesale and consumer prices. These in turn affect the value of the nation’s currency, and as a result, the level of economic activity in the country.
Because of the way that inflation affects interest rates, when an economic number indicative of inflationary trends is released that points to an increase in inflation, this will usually be bullish for the currency of that nation. This effect arises because interest rates would tend to be adjusted higher to fight this inflationary tendency.
Conversely, if the number indicates a decrease in inflation, this will tend to put downward pressure on the currency, because interest rates would be adjusted lower as a result.
The U.S. Consumer Price Index
A standard gauge of inflationary pressures in an economy consists of reviewing changes in the level of consumer prices. In the United States, the inflation indicator most commonly watched by forex traders is known as the Consumer Price Index or CPI.
The CPI is released monthly by the U.S. Bureau of Labor Statistics. This indicator is also known as “headline inflation”, and its release is generally between the 13th and the 19th of each month.
Calculating the Consumer Price Index involves taking the weighted average pricing of a fixed basket of consumer goods and services, with each product in the basket assigned a fixed weight depending on the importance of the item. Consumer goods and services in the CPI include among others: food, housing, clothing, education, transportation, medical care, education and recreation.
An additional related number, the Core CPI, uses the same weighted average scale as the CPI, but excludes food and energy prices from the calculation to give a more accurate measure of inflation without these volatile components which tend to make up a quarter of the regular CPI.
Core CPI is typically more important to traders and the Federal Reserve as a measure of actual inflation since it tends to provide a more representative view of the inflationary forces acting in the U.S. economy.
The Chain Price Index and the Personal Consumption Expenditure
Another less popular but also significant index for inflationary trends in the United States consists of the Chain Price Index for Personal Consumption Expenditures, or the PCEPI.
This index is released monthly by the Department of Commerce’s Bureau of Economic Analysis and forms part of the personal income report. The PCEPI has less of a forex market impact than the CPI because it is considered more predictable and so it tends to present less risk of a surprise to the market when it gets released.
Furthermore, the PCE or Personal Consumption Expenditures number measures the changes in prices of consumer goods and services which are affected by inflation by examining household expenditures.
The Chain Index part of the PCE calculation considers the varying level of consumer consumption based on price moves, and so provides another useful inflationary measure for the U.S. economy.
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