We can define inflation as the general increase in prices of goods and services in connection with a currency at a specific time period. When the price of these resources increases, the purchasing power of the country’s monetary unit drops so the people of the country can buy fewer goods and services and this has an overall impact on the economy. In other words, this means that inflation causes the purchasing power of a currency to decline.
Inflation has a negative effect on all members of society regardless of their socioeconomic level, and obviously, it affects all consumers in the economy of a country, for this reason, is one of the most important economic indicators for Central Banks and investors of financial markets such as Forex.
Many economists believe that inflation can be positive if it has a moderate level. Meanwhile, central banks invest huge efforts to keep inflation within well-established limits, so that the economy of the country can take advantage of the positive aspects of inflation while at the same time the negative effects of it are minimized.
One of the main measures implemented to counter the inflationary pressure is rising interest rates. When interest rates rise, commercial banks proceed to increase the interest of the loans they make to their customers.
Effect of inflation on the Forex market
Every investor tries to obtain a high rate of return combined with a low level of risk in their investments. Investors and speculators in financial markets such as Forex also look the same. So in the case of this market, when a central bank increases the interest rates, it is almost certain that at the same time the demand for its currency will increase. This in turn causes a rise in the price of that currency against the other.
For example, let’s suppose that the interest rate of the currency A is greater than the interest rate of the currency B, so it would be expected that the exchange rate of the currency pair A/B experiment an increase due to the raising of the demand for the currency A in relation to the demand for currency B.
Another measure implemented usually to control inflation is to raise reserve requirements on banks. When central banks make a decision of this type, the amount of money that banks can let out decreases, which directly results in a limitation and reduction of economic resources present in the economic system. In other words, there is less money in circulation in the country.
This process causes the price increases to occur more slowly because there is less money available to acquire the same amount of goods or services, which in turn causes a reduction in demand. This can cause an increase in the value of a currency against another, mainly for speculation trades, which in the case of the Forex market constitute the largest percentage of the total trading volume.
When there are such conditions, the Forex market presents an important opportunity to buy as the currency in question will suffer a decrease in its availability (the supply of this currency is reduced) due to the increase in reserve requirements, which also tends to be accompanied by increases in prices in different currencies. So, when the central bank of an important economy announces an increase in reserve requirements it is almost sure that the market will move.
The actions of the central banks which have more impact on the Forex market are those in which these banks trade directly on the market. These transactions involve the purchase or sale of its own currency, which is made through agreements between banks in which there is a right of repurchase for the Central Bank. The objective of these operations is to increase or decrease momentarily the monetary resources present in the system.
On some occasions, central banks raise interest rates as a resource to support this strategy so at the same time they make massive purchases of its own currency in order to achieve a more effective reduction of monetary resources. An action of this type often has an important impact on the market in which there is a movement in the prices quite strong.
One of the least used actions to minimize the effects of inflation is currency appreciation. The reason why this economic policy is rarely used is due that it can be implemented only in economies with a fixed currency exchange rate system that is controlled by the authorities. When a country has an appreciation of its currency due to this action, its economy experiences a reduction in production costs and raw materials that over time will cause a decrease in consumer prices.
In general, it can be said that the inflation data of the major global economies (U.S., Europe, and Asia) tend to have a significant impact on the currency market, especially if these data are quite different compared to the forecasts. For this reason, it is highly recommended that Forex market speculators pay close attention to news about inflation in those countries.
Effects of the inflation in other financial markets
In the case of the stock market, usually, an increase in inflation may be accompanied by a decrease in the price of the shares of many companies for fear of a reduction in the demand for their goods and services due to the reduction of the buying power of the consumers. And with the subsequent increase in interest rates that often accompanies rising inflation, it is expected an important decline in requests for loans from consumers, who will be more cautious about investing.
If inflation and interest rates are high and there are no signs that they will decrease significantly in the short and medium-term, lenders will tend to compensate for the rise in interest rates. Therefore, the debtor will pay a higher rate on the loan. This fact plays a significant role in the sense that it makes it more difficult that investors (companies and individuals) to invest funds in the stock market which can, in turn, cause a drop in it.
Logically, a reduction in inflation often causes a general rise in the prices of the stock market because consumers are expected to spend more on products and services and are more inclined to borrow and invest, as well as companies. However, this is not a rule. Sometimes, we see the opposite effect, i.e. a general decline in the market when there is good news on inflation, which is shown in the fall of stock indices of great importance such as the Dow Jones or the S&P 500. This is because sometimes investors and speculators are wary about the good results shown by the economy, so they prefer to bet that the economy will soon start showing negative signs which will have a negative impact on markets. We must remember that often what moves the markets is what people think will happen than what actually happens.
In the case of the bond market, inflation has a negative effect on the future purchasing power of bonds. In other words, the higher the current inflation and future rates of inflation forecast, the higher the return on bonds. In this case, investors tend to demand higher returns to offset the negative effects of inflation, which is one of the key factors of the different characteristics which establish at the end the interest rates on bonds. It is therefore critical for both issuers and investors to properly calculate the time of issuance of the bonds in order to ensure that the effects of inflation are limited. The calculation of the emission moment involves the projection of the revenue stream of the bond to its maturity, so as to ensure that the return outweighs the potential increase in inflation.