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Inflation and Why it Matters for the Currency Trader

Inflation plays a vital role in the value of a currency. For this reason, any currency trader considers inflation projections before buying or selling a currency.

Some people argue that scalpers (traders that take multiple trades during a day) aren’t affected by the economic news. Hence, inflation won’t matter for the one that trades for only the next ten pips.

However, that’s a wrong approach. Because of its importance, inflation has the power to influence both short-term and long-term volatility.

Not to mention, that inflation drives the monetary policy. But why is inflation so crucial in Forex trading and what is the minimum a trader must know?

Inflation in Forex Trading

Inflation refers to the changes in the price of goods and services in an economy. Hence, it strongly relates to the value of money.

Economists analyze inflation both at the consumer and the producer level. On the consumer side, the Consumer Price Index (CPI) comes out monthly.

It shows the changes in the price of goods and services on the consumer. It is, by far, the most critical release, more important than the inflation on the producer side (PPI – Producer Price Index).

Because of that, the PPI tends to have little influence in Forex trading. It creates less volatility as the market considers it a second-tier data.

However, in the end, PPI will pass onto the consumer, so drastic changes in the value of the PPI may result in changes of the portfolio allocation for some traders.

In some previous articles here on the Trading Academy, we argued that all that matters in Forex trading is the interest rate. Central banks change the interest rate based on how the economy performs and their mandate.

But any central bank’s mandate considers inflation. In fact, all major central banks (FED – the Federal Reserve of the United States; ECB – European Central Bank; BOE – Bank of England; RBA – Reserve Bank of Australia; BOC – Bank of Canada; BOJ – Bank of Japan, etc.) have inflation as the pillar of their mandate.

While the interest rate represents the monetary policy tool, inflation remains the reason why central banks change the interest rate level.

A rule of thumb says that higher inflation (a.k.a. when prices rise) results in the central bank raising the interest rate. In doing that, the central bank tightens the monetary policy, draining liquidity from the economy.

On the other hand, when inflation falls, central banks lower the rates, easing the monetary policy. They’ll flood the economy with cheap money, stimulating commercial banks to lend to people and businesses.

Part of every central bank’s mandate, a certain inflationary level keeps an economy on track. The conventional wisdom (even though there’s some debate over it) says that inflation levels below or close to two percent help calibrate a growing economy.

Put simply, anywhere around two percent, the inflation is at a “normal” level.

Inflation and Monetary Policy

The CPI comes out monthly, but quarterly and yearly changes matter too. Because these changes influence the interest rate level, traders react immediately when the CPI comes out.

No wonder that the Forex market holds ranges in the days before the CPI in the United States, United Kingdom or the Eurozone comes out. And, if the actual value differs much from the forecasted value, traders act in an instant.

The more the actual value differs from the forecast, the bigger the reaction will be. Because trading is a game of expectations, traders anticipate that the central bank will change the interest rate level due to changes in inflation.

But the change in prices suffers some distortions. An interesting relationship is the one between the oil price and inflation.

When the oil price fell from over $100 to around $30, it sent a shock-wave through financial markets. Suddenly (albeit with a few months’ lag), inflation dropped significantly around the globe.

Major central banks around the world faced the same problem: lack of inflation. Hence, the economy didn’t grow, became gripped by depressed inflation, and, in some cases, a deflationary spiral appeared.

To avoid a global deflationary environment, central banks acted together. They flooded the markets with cheap money, printing fiat currencies using all kinds of innovative monetary policy solutions, like:

  • Quantitative Easing. Via a process where the central bank buys its government bonds, stimulating the economy and physically printing money (nowadays electronically, but the idea is the same). The Fed, ECB, BOJ, BOE, SNB, and other banks launched various rounds of QE, with some being in place to this day.
  • -LTRO’s. Long-Term Refinancing Operations were widely used in the Eurozone to allow troubled banks access to ultra-cheap loans from the ECB. Later, because of its success, TLTRO (targeted LTRO’s) continued the same line.

In most cases, such measures worked. The United States reversed the course, inflation picked up, and the Fed now raises rates as inflation gets closer to the target.

The Eurozone sees inflation picking up too, but the ECB lags behind the Fed. Discussions began to taper (reduce) the QE program and start normalizing the rates.

It was enough to propel the Euro higher. For almost the entire 2017, the Euro trended higher against nearly all other currencies. Remember why? Trading is a game of expectations, and traders already positioned for the ECB to start the normalization process.

Interpreting the CPI Data

The CPI data has a secondary role in Forex trading. What matters is the Core CPI, both for the FED and the ECB.

Combined, the two central banks account for the two largest economies in the world, with the Eurozone economies rivaling the United States. Hence, the two central banks’ actions dictate the overall monetary policy in the currency market. They set a course of action for other central banks in various jurisdictions around the world.

The core data doesn’t consider the changes in energy prices, food, and transportation (see the oil’s influence?). They’re too volatile and distort the data. Hence the central banks tend to ignore them.

Therefore, the Core CPI is the economic news to watch, as it is the preferred measuring tool for inflation that the ECB and Fed use.

Conclusion

Ironically, last years saw central banks fighting to produce inflation. They all cut the interest rates to depressed levels, and some even went the extra mile: moved the interest rate level below zero.

In Switzerland, to this day (2018), the SNB (Swiss National Bank) keeps rates at -0.75%. Yes, with a minus.

Only some years ago the concept of negative rates was exotic. No one knew how the economy would react, as there was no precedent.

Nowadays, capitalistic economies pride themselves on having one more tools to use, as negative rates proved their usefulness. But why would central banks go to such extremes?

Examples help best. We have one for both extremes.

On the one hand, there’s Japan. For over two decades, the Japanese economy is in a deflationary spiral. Simply put, the consumer isn’t spending money, and the economy isn’t functioning as it should.

Plenty of factors could be affecting this, such as demographics, culture, and so on. However, from an economic point of view, if one applies the same principles, the outcome should be the same.

In Japan, it didn’t work. With a gripped economy, future generations have a bleak outlook, and BOJ faces one of the toughest jurisdictions to govern from a monetary policy point of view. Effectively, there aren’t any tools available to use, unless the central bank goes into some unprecedented territory such as “helicopter money” (helicopter money is a concept widely debated – a.k.a. free money provided for the people, to increase spending and jump start the economy).

At the other extreme, there’s Venezuela. With inflation ramping over 6000%, the value of money disappears by the hour.

In between deflation and the Venezuelan experience, central banks sit and set the interest rate levels to accommodate economic changes. In earnest, they set the value of a currency, and that’s all that matters in Forex trading.