Inflation and Why it Matters in Currency Trading
InvestingOnline.com
11/07/2018, 10:50Inflation is a crucial piece of economic data that influences the value of all currencies. Released in each country, it creates high volatility in the Forex market.
In economic terms, inflation is the CPI (Consumer Price Index). Released monthly, it reflects the value of money.
Why do traders care?
Inflation as Part of Every Central Bank’s Mandate
Central banks safeguard the value of money. Part of every central bank’s mandate, price stability is what drives their decisions.
But price stability depends on inflation. When and if central banks manage to keep inflation at bay, the price enjoys stability. More precisely, people’s money and fortunes hold their value.
Economic studies have shown that certain inflation levels do help an economy. Hence, central banks target moderate inflation as a stimulant for economic growth.
The standard in today’s world is two percent. While not a fixed level, central banks target values around two percent: below, but close to the level.
Sometimes, depending on the strength of the economy, central banks target a symmetrical inflation mandate.
It means that the central bank is willing to let inflation above the two percent target in a symmetrical way as below. As such, a bandwidth or a corridor for targeted inflation is 1.8%-2.2%.
Any deviations from the corridor represent anomalies. Conclusively, deviations show economic anomalies.
For an economy to have a healthy, moderated growth, and price stability to exist, inflation must be at target.
When it deviates, central banks act.
Inflation and the Interest Rate Levels
The way to stir inflation is through the interest rate level. Higher inflation triggers higher interest rates, and traders will buy the currency as a consequence. Effectively, the expectations grow that the central bank will hike the rates soon, possibly at the very next meeting.
The opposite happens when inflation falls below the target. The central bank will act quickly by cutting the interest rate level. As such, it hurts the currency as traders will react immediately by selling a currency that has a lower interest rate.
Conclusion
Inflation is the reason why central banks adjust the monetary policy. Hence, inflation shows the value of money and triggers reactions that influence the future value of money.
Because trading the currency market is a game of expectations, traders will react on the spot on any central bank decision, and not wait until the effects are visible in the economy.
If there’s an economic data to keep an eye on when trading currencies, that’s inflation or the Consumer Price Index.
