Understanding Inflation And Forex

Most people, even without a background in economics or finance, know that inflation means that the value of a currency is going down.

Broadly speaking, this is translatable in some sense to the currency markets. If one currency has higher inflation than another, it’s reasonable to think that its value will decrease when compared to the other. This would be a basic source of fundamental analysis for trading.

However, financial markets are more complicated than that. And while an economic understanding of inflation is more than useful for traders, the impact of inflation and its data on currency markets is a little more sophisticated. So let’s take a little deeper dive into inflation and how it applies to forex.

What About Deflation?

Negative inflation, or deflation, is generally not something seen in modern fiat currencies. It’s typically only an issue when there are significant economic problems in a given economy. When the next recession eventually rolls around, we can talk about the effects of deflation. For now, it’s the different rates of inflation that inform traders and market reaction when tracking inflation data releases.

Something to keep in mind first is that the Consumer Price Index is not the same as inflation. Even though, for practical reasons, CPI is generally used as the measure of inflation. Second, we should note that different countries use different methodologies to determine their CPI and gauge of inflation.

Consequently, inflation rates are not necessarily comparable directly between countries. If Country A has an inflation rate of, say 2.3% and Country B has an inflation rate of, say 2.4%, it doesn’t necessarily mean that Country B’s currency is losing value faster than Country A’s.

Variations in how we calculate inflation can account for that difference. And it might even by the reverse: that Country A’s currency gets stronger.

The Market’s Expectations Change Everything

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However, each data release is subject to the impact of many factors at ...

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