According to Jonas Goltermann, a senior markets economist at Capital Economics, the return of higher and unstable inflation across economies would cause a spike in exchange rate volatility and the eventual depreciation of currencies in countries with the highest inflation prints.
Forex traders must consider the effects of inflation on their trading strategies and the exchange rates since it could lead to a lower return on investment (ROI). This article will show you the effects of inflation on the forex market and strategies to work around it.
Impact of Inflation on Foreign Exchange
Inflation is usually the sign that the value of money is declining, making it more difficult to buy goods in the market. It has always been a concern for many consumers and the world’s central banks, who adjust monetary policies to prevent high inflation rates.
To illustrate, a country with consistently low inflation rates shows a rise in its currency value, making its purchasing power stronger compared to others. In contrast, countries with high inflation rates exhibit depreciation in currency value and are usually accompanied by higher interest rates.
It is one of the most important economic indicators for central banks and forex traders in determining foreign exchange rates. For instance, trading with a currency that has a 5% inflation rate will have a 3% higher real exchange rate when traded with a different one with a 2% inflation rate.
Correlation of Inflation, Interest Rates, and Exchange Rates
Interest rates, inflation, and exchange rates are highly correlated. Central banks manipulate interest rates to influence the other two factors, impacting their currency value. Higher interest rates offer lenders a higher ROI, attracting more foreign investments that raise the exchange rates.
Meanwhile, lower interest rates can decrease exchange rates, but they can also drive consumer spending and economic growth. It usually gives positive outcomes in the currency value and makes money easier to borrow. However, a decrease in inflation can lead to downward pressure on the currency since interests would be lower.
The biggest determiner of the currency’s value and exchange rate is what the monetary system wants to get out of it, like attracting more investors or driving economic growth. Investors should consider these factors to determine how safe their cash holdings are in the currency before measuring profit.
Actions to Take as a Forex Trader
As a forex trader, you must invest in a currency that will generate the greatest ROI possible, strengthening its value. Since you will need to consider inflation in your trading strategies, you can take these actions to create a solid plan.
If Inflation Will Not Rise
Inflation rates can settle even if trends show an upward direction. For instance, the US central bank believes the current rise in prices is only transitory due to supply chain restrictions from COVID-19. Thus, they will not increase interest rates in the immediate future.
If that is the case, you do not have to worry about inflation and may have to consider other factors like economic performance, debt, and account deficits that can also influence forex prices. It will help you determine the next steps of your trading strategies.
If Interest Rates Rise Without Affecting the Economy
If you think interest rates may rise, then consider investing in currencies with higher interest rates. A country with a higher interest rate can have a stronger currency than others, which can yield a greater ROI. Since it will not affect the economy, you will not have to worry much about other determiners affecting the currency.
If Economies will be Affected by Increased Interest Rates
If you think economies will be affected, consider creating a hedging strategy. To start, look for two forex currencies with a positive correlation, then open one long investment and one short one.
You do not have to stick with currencies since you can pair one with a commodity like gold. While it is a more grounded strategy, it can protect you from any fluctuations in your investment and help diversify your portfolio.
Trade Forex with Trusted Brokers
Forex trading can be a challenging investment to take, especially with factors like inflation and interest rates that affect it. At Fair Forex, we provide a platform for all traders to learn about forex and make the best trading strategies. Visit our home page to learn more about our services or email us at [email protected].