Inflation and How It Affects the Currency Market

Hello there, this is and this video shows what inflation is, or what the Consumer Price Index is, and why it matters for the market, for all these currency pairs as it affects the market’s volatility.

Inflation Definition

inflation-definitionInflation, or the Consumer Price Index, is released by any economy, usually monthly, but also the yearly data is interpreted. In some countries, if you check the economic calendar, there are two measures of inflation – one is the headline inflation and another one is the core inflation. Typically, the core inflation does not take into account the energy prices, or the oil prices, because they are considered to be too volatile.

Inflation sits on every central bank’s mandate. Every central bank in the world, including the Fed, that has a dual mandate, has a mandate or part of it that refers to price stability. But price stability does not refer to the market not traveling to the downside or to the upside as, for example, here. Price stability refers to inflation not exceeding certain levels. The 2% level is perceived as the one not affecting the zero, deflationary level, and not high enough to affect the value of money. Therefore, central banks try to calibrate inflation in such a way that it will not affect price stability.

Hence, higher inflation leads to central banks raising interest rates, and that is positive for a currency as long as inflation does not exceed the 2% level – the threshold of most central banks. Below, but close to 2% in the case of the ECB, the Fed also signaled that 2% inflation is in line with its view of price stability.

So, high inflation, higher interest rates, are positive for a currency as long as the inflation does not exceed by much the 2% threshold. But what causes higher inflation? What is inflation? Inflation refers to the change in the price of goods and services from one period to another – for instance, from one month to another. What goods are considered?

There is the consumer basket, and in this basket, there are many items monitored by statistical institutions and then price changes illustrate if inflation moves to the downside or to the upside. Rampant inflation, or much higher inflation than the two percent level leads to hyperinflation. This is something that you have heard probably from Venezuela where the local currency means nothing anymore or usually some frontier or emerging markets also had episodes in the past with higher inflation.

When inflation falls, for instance if it reaches 5% and then falls to 2%, that is called a disinflationary process – you still have inflation, but positive one. The threat and the reason why central banks consider inflation at the 2% appropriate is the threat that the inflation will move to the zero level and when that happens, that is called deflation – much more difficult to fight by central banks by using conventional monetary policy tools, as we have seen in Japan that fights deflation for more than two decades.

Oil Market and Inflation

oil-market-inflationAnother thing to consider here is what drives the change in prices higher or lower. A major driver is the oil market or the oil prices. Why oil prices? There is not only one price for oil, but many – WTI, Brent, OPEC, and so on. Oil prices drive inflation higher or lower.

The higher the price of oil, the higher inflation is. Central banks will raise interest rates and the currency will appreciate, as long as the interest rates remain around the threshold. What happens if the price of oil moves much higher and inflation does the same, but the central bank raises the interest rate in order to push inflation lower? What happens if the price of oil keeps pushing higher and higher?

This is why central banks look at inflation from a different perspective. They are ignoring the changes in transportation as the oil market proves to be extremely volatile. Nevertheless, oil is a major driver of inflation.

Look at this ratio as influencing the value of all currencies. For instance, in April 2020, oil futures closed below zero, as there were no buyers for the futures contracts. It closed -$40. Producers had no space to store the oil anymore and they were willing to pay for someone to come and pick the oil up. Such a move lower in oil prices means that there is no demand. No demand means slowing global economy. Slowing global economy means that the central banks will lower interest rates. Lower interest rates are negative for a currency, and so on. This is the logic behind inflation.

From this moment on, when you look at inflation, consider the price of oil, or the changes on the price of oil and what it means for a central bank when it analyzes the latest inflation report. High inflation is positive for a currency as long as the inflation rate does not exceed by much the 2% threshold.

Sum Up

sum-upTo sum up, check the oil prices, higher inflation leads to higher interest rates, positive for a currency; lower inflation leads to lower interest rates, which is negative for a currency; if inflation drops below zero, this is deflation, even worse for a currency; if inflation falls into positive territory, that is a disinflationary process.

Finally, keep your attention on central banks on the core CPI, and not necessarily on the headline inflation.
Thank you for being here and have a great day. Bye bye.