Analysis

Inflation and Currencies

Inflation strengthens a currency in the short run, because it makes the central bank more likely to raise rates, and weakens it in the long run, because it erodes what the currency buys. Which effect dominates on any day depends on what the market expects the central bank to do about it.

Shopping baskets stacked outside a supermarket

The short run

Central banks target about 2 percent inflation. An inflation print above expectations implies tighter policy and higher rates, which draws capital in and strengthens the currency within seconds of the release. The reaction depends on the surprise against the consensus forecast and on whether the bank has said it will look through inflation or act on it.

The long run

Over years, a currency whose prices rise faster than its neighbours' buys less abroad, and exchange rates tend to adjust to compensate, which is purchasing power parity. This is why the Turkish lira and Argentine peso fall over time despite very high interest rates: the real rate is negative.

Reading the data

  • Headline CPI: all items, the public figure.
  • Core CPI: excluding food and energy, the central bank's focus.
  • Month on month: the most current signal.
  • PCE in the US: the Fed's official target measure.
  • Inflation expectations from surveys and bond markets.

Tightening and easing cycles

A currency usually strengthens through the middle of a tightening cycle and weakens near its end, as the market prices the cuts to come, and the mirror applies to easing. The peak in rates is rarely the peak in the currency.

The course lesson on inflation data

Trading forex, CFDs and other leveraged products carries a high risk of losing money. This guide is general education, not advice.

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