In the realm of forex trading, many analysis tools exist but two of them stand out: Technical analysis and Fundamental analysis. Some traders stick to either of the two whilst most combine both to help them make informed decisions so as to avoid unnecessary losses and enhance their profitability.
Fundamental analysis involves the analysis of economic, social and political activities and factors that are likely to affect the value of currencies across the world. Technical analysis on the other hand, deals with the analysis of historical data to forecast the movement of currency prices.
One of the may factors that influence fundamental analysis is inflation. Hence this article seeks to demystify the effect or impact inflation has on currency values. Every forex trader who wants to make it in this industry must adequately understand inflation and how to use it to determine the strength one currency against another.
What Is Inflation?
Inflation is the term used by economists to describe the phenomenon where by there is a general rise in the prices of goods and services over a long period of time. Due to this phenomenon, the purchasing power of consumers is drastically reduced and this eventually negatively impacts the value of the currency. When inflation is therefore high, the currency can buy fewer goods and services than it could have bought earlier. And this leads to decrease in the real value of money and assets.
How Does Inflation Impact Currency Values?
The rise in inflation in a nation devalues the currency eventually. This happens due to increase in price of goods and the reduction in the purchasing power of the currency. It makes investing in such economies less attractive to foreign investors.
Inflation is known for its ability to wickedly erode the value of the savings and investments denominated in that currency resulting in an overall decrease in demand for it.
Another danger of high inflation is its ability to cause uncertainty and instability in an economy. This trickles down into the shying away of foreign investment, a major cause of currency depreciation. However, deflation (low inflation) usually strengthens currencies since it is an indicator of general stability and strong purchasing power.
Inflation And Exchange Rates
The world is such a connected place as well as economies of various nations are interconnected. Due to this interconnectedness of the global economies, inflation and its effect on exchange rates can make or break a nation’s financial strength or stability. For example, a country that is import driven will actually suffer should its currency become weak. The price of goods and services in the country of purchase may not change but the importers may have to use more of their home currency to buy the same product due to the devaluing of their currency.
Exchange rates have the ability to affect trading from individual purchasing ability to international trading. Inflation does act like what can be called “silent taxes” on the purchasing ability of a particular currency. When inflation do rises unattended to, it can trigger a vicious cycle of currency devaluations. As inflation rises, it makes the country’s exports more competitive and makes imports more expensive.
Factors Affecting the Relationship Between Inflation and Currency Values
The inflation in a particular country is known to affect the value of the currencies used in those countries. There are factors that affect the relationship between inflation and currency values. Below of some these factors:
- Interest rates: Central banks are used to the practice of using interest rates to control inflation. When inflation increases, central banks also increases interest rates so as to reduce the amount of money circulating and also increase investor confidence in the economy. Ultimately, these changes in interest rates will surely impact the value of currencies. Inflation is also thought to occur when plenty money is chasing after fewer goods
- Economic growth: A strong economic growth of a nation is known to lead to higher inflation. The stronger an economy, the higher the inflation is likely to be depreciating that currency eventually.
- Government policies: Countries are governed by governments and political parties. These policies such as Fiscal and Monetary policies of governments greatly affect inflation rates and currency values. A Fiscal policy is concerned with the use of government’s spending and taxation to influence the economy. Monetary policy is a set of tools (open market operation, discount rate, reserve requirements, quantitative easing, etc) that central bank of nations uses to promote sustainable economic growth by determining the overall supply of money that is at the disposal of the nation’s central banks, consumers and businesses.
- Global economic conditions: Global economic factors such as geopolitical events, and commodity prices and trade flows can affect inflation and impact currency values. The Covid-19 pandemic really shook some economies devaluing their currencies and increasing inflation in them.
Methods Of Measuring Inflation And Its Impacts
Consumer Price Index (CPI)
One of the factors monitored in forex trading is Consumer Price Index (CPI). Such news releases do move the market because of the weight of information it carries. The Consumer Price Index (CPI) is an effective method that is widely used in measuring inflation. It is used to monitor and track the fluctuations in the prices of specific goods and services that are usually household dependent. Economists use this indicator to monitor and assess the rate at which prices do rise within a period of time and the impact inflation is exerting on the purchasing power of consumers.
The Purchasing Power Parity (PPP) theory
The Purchasing Power Parity (PPP) theory is a method used by economists to assess the impact of inflation on currency values. It is a macroeconomic analytic tool used to determine the similarity of economic productivity and living standards between two economic states. This theory states that, the exchange rate between two currencies should be adjusted to ensure that the prices of goods and services are equal in both countries. This means that should one country experience higher inflation rate than another, its currency must depreciate in relation to the other currency.
