The sky-high level of inflation is the most prevailing issue all over the world these days, and it is on top of every investor’s mind. Moreover, inflation within the U.S. is sitting at a high level.
Higher inflation could be problematic for both the economy and consumers on several counts. So, the Federal Reserve wants to tame it and it is planning to do so by its monetary policy measures.
If the Fed continues to keep rates higher for longer, the rate at which it lends funds to other banks will remain higher.
This could mean low borrowings from these banks and from the consumers, and it ultimately leads to less money in circulation in the market. That’s one of the simple ways in which a central bank can try to bring down inflation rates.
But it’s not as easy-peasy as it sounds. There are many factors involved that can influence inflation, and tinkering any one of them could have a cascading effect on the others.
So, to make it simpler, let’s focus on the effects of inflation on exchange rates.
To do that, let’s understand why the U.S. Dollar (USD) has been strengthening since 2021.
The USD was in a downtrend since the start of the pandemic in 2020. But that has changed since the end of January 2021.
We saw a U-turn in the market and the USD broke its downtrend line to the upside, as can be seen in the chart below…
USD’s Rally Since 2021
How did this happen?
The simple answer to that is ‘inflation.’ As inflation rose, the dollar started strengthening.
The consumer price index (CPI) based inflation has been climbing since 2021. Despite the cool off we saw recently, it’s still in an upward trend.
This bears importance if you are a Forex trader.
One of the core concepts of Forex trading is understanding that inflation will affect interest rates, and interest rate expectations will affect exchange rates.
So…
Higher Inflation = Higher Interest Rates = Stronger Currency
And this is evident from what we’ve been seeing lately.
As the CPI-based inflation started to move higher, the USD has been in an uptrend.
That tells us, as a trader, one has to look at fundamental inflation announcements in the economic calendar to plan your trades for potential profits.
A higher inflation reading will mean bullish sentiment for the market, while a lower reading will mean bearish sentiment.
Take the GBP currency basket for instance…
Suppose the market expects to see the U.K. inflation figure to come out at 0.5%.
However, imagine the actual inflation rate reported is higher, say 0.8%.
In this case, we could expect the GBP basket to potentially strengthen during that trading session.
And that’s because of the same formula we discussed: Higher Inflation = Higher Interest Rates = Stronger Currency.
So, that’s one simple way to predict which way the exchange rates are most likely to move during fundamental inflation announcements. And consequently place your Forex trades accordingly to target some potential profits.
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