Interest Rates, Inflation and Currencies

Real rates

A 5 percent interest rate with 4 percent inflation pays 1 percent in real terms; a 3 percent rate with 1 percent inflation pays 2 percent. Capital chases real returns, so the second currency is more attractive despite the lower nominal rate. Real rate differentials explain currency moves better than nominal ones, particularly when inflation diverges between economies.

Short run versus long run

The short-run effect dominates trading. The long-run effect explains why high-inflation currencies such as the Turkish lira lose value over time despite very high nominal rates: real rates are negative and the purchasing power erodes faster than the interest compensates.

Applying it to a pair

Take EUR/USD. Compare US and eurozone inflation, the two policy rates, and the expected path of each. If US inflation is falling faster and the Fed is expected to cut sooner, the US real rate advantage is expected to narrow, and the framework favours the euro. If the market already prices that, the trade needs a further surprise to work. The framework gives direction and the calendar gives the catalysts.

Exceptions

Risk appetite overrides the framework in a crisis, when the dollar strengthens regardless of rates. Intervention overrides it in the yen and the franc. And politics can override it anywhere, from an election result to a debt-ceiling standoff. The framework explains most months; it does not explain every day.

Key takeaways

• Real rates, nominal minus inflation, drive capital flows.
• Inflation strengthens a currency in the short run via expected tightening and weakens it in the long run via purchasing power.
• Compare inflation, rates and expected paths across the pair.
• Risk appetite, intervention and politics can override the framework.