According to "trading-secrets" inflation has long been a serious enemy of economic growth as global central banks are constantly trying to keep inflation under control by adjusting monetary policy. Inflation can have a significant impact on currency exchange rates. The perception of inflationary trends is one of the key elements affecting the central bank's monetary policy.
Inflation can be largely described as what happens when a lot of dollars start to chase very few items. This is an oversimplification of the issue, but it gives an idea of the nature of inflation, which generally does not indicate the increase in the value of goods, but the devaluation of paper money used to purchase those goods.
Because inflation affects all levels of society and all consumers in the economy, it is one of the most important economic indicators for central banks and forex traders alike.
Inflation and Forex Rates.
Currency exchange rates can be "nominal" in the sense that the rate is set in the market, mainly in the global foreign exchange market, or "real" means the nominal nominal rate, adjusted for inflation.
While nominal prices can be easily accessed by reviewing forex market prices, real exchange rates must be calculated.
For example, if a country has an inflation rate of 5% and the country of the corresponding currency has a 2% inflation rate, the country's first currency will have a real exchange rate of 3% higher than the second country, with the nominal rate.
Real exchange rate definitions.
There are two sets of definitions of the real exchange rate, where the first relates to the reward of purchasing power.
According to PPP definition, the real exchange rate is determined by the nominal exchange rate adjusted by the ratio of the foreign price level to the local price level of a particular commodity or basket of commodities.
The other definition of the real exchange rate is related to negotiable and non-negotiable goods.
The way to be determined is by taking the relative prices of tradable and non-negotiable items to form an indicator of the level of the country's competitiveness in foreign trade.
The reason for this definition is that the cost differential between the two countries is directly related to the relative price structures of both economies.
Actual exchange rate.
Also known as the weighted trade exchange rate. This rate consists of a multilateral exchange rate, which consists of a weighted average exchange rate for both domestic and foreign currencies, with each country's weight equal to its share of trade.
The effective exchange rate measures the average price of a domestic commodity for the commodity price of its foreign trading partners, using each country's share of trade by that country's weight.
The following sections describe different ways of assessing inflation levels used by fundamental analysts with a focus on the US economy, as well as the impact inflation controls can have on the Forex market.
Effects of inflation in the Forex market.
Central banks tend to fight inflation by adjusting interest rates as an essential part of their economic control policy. As a result, it may raise the level of short-term interest rates to contain inflation. In addition, they may reduce these same rates to counter deflationary tendencies and stimulate the economy by making money easier to borrow. In this way, central banks indirectly affect wholesale prices and consumers. This in turn affects the value of the country's currency and, consequently, affects the level of economic activity in the country.
Because of the way inflation affects interest rates, when an economic figure showing inflationary trends indicates inflation increases, this is usually a rise in the currency of that country. This effect arises because interest rates will tend to be further adjusted to combat this inflationary trend.
Conversely, if the figure points to a drop in inflation, this will lead to downward pressure on the currency, as interest rates will be adjusted as a lower result.