Inflation Explained: Why It Matters for Forex Traders

Technical analysis is not enough. Studying charts, working with indicators, and obtaining signals only covers half of the work. The rest must be done through fundamental analysis, looking outside at the real market and the real economy. In short, it is necessary to trade based on economic data. One of the most important economic data points is undoubtedly inflation. A true obsession for some countries (consider Germany, which still bears the trauma of hyperinflation from nearly a century ago), it is the cornerstone of monetary policy for central banks, the North Star that guides their actions. In this article, we will discuss the topic of inflation from the perspective of Forex Trading. We will provide a comprehensive definition of inflation and describe its impact, both direct and indirect, short-term and long-term, on the currency market.

What is Inflation?

Inflation is, very simply, the variation in recorded prices expressed as a percentage, measured within a reference period and at the lowest level of the supply chain: retail. In simple terms, inflation is calculated by studying prices as they are found "in stores" for products or presented to end customers for services. Obviously, inflation does not take into account all prices. Or rather, it does not consider all products, but rather a basket. This basket is created by selecting the most widely used products. However, there may be multiple baskets, depending on the type of inflation. Here are the most important types of inflation. Headline Inflation. Simply known as "inflation," it is the inflation that takes into account the standard basket. Core Inflation. It is the inflation that does not consider products characterized by excessively volatile prices. In fact, both food and energy, particularly oil, are excluded from the core inflation basket. Although not often mentioned in general information, it is core inflation that represents the most genuine reference point for central banks and investors, also because it is the only one capable of providing a real overview of prices. False positives can easily emerge if only headline inflation is used and core inflation is not considered. Consider last year, when inflation seemed on the verge of returning to normal in Europe, but it was simply inflated by food and energy prices. Inflation has a huge impact on the currency market, but also on the real economy. It is obvious that if prices rise, people - until they reach a breaking point, which leads to the black market - tend to buy because they know that if they delay the purchase, they risk losing money. If prices fall, and the outlook is clear, consumers tend to delay purchases because they know that, in the near future, they will be able to spend less to buy the same product. Inflation imbalances, in either direction, generate heavy consequences in economic life. If prices increase excessively, the purchasing power of households is reduced, and they become poorer. If prices decrease, due to the "delay" dynamics we mentioned earlier, sales suffer, companies close, and jobs are lost. For this reason, inflation is subject to intervention by central banks, which manipulate it using the lever of interest rates. It is precisely based on this mechanism that one of the impacts we will discuss shortly, the direct impact, occurs.

The Direct Impact of Inflation

Inflation has a direct, or almost direct, impact on the currency market. It has this impact for a simple reason: it guides the actions of central banks, and these significantly modify the relationships between currencies. To understand this mechanism, it is important to delve into the tasks of central banks in detail. Except in rare cases, their goal is to bring inflation to a desirable level that favors normal economic activities, the so-called target. Now, the debate on what the best inflation rate for the economy is still open, but for now, the conventional measure of 2% has been accepted almost everywhere. In short, if prices increase by 2% per year, the best conditions for balanced growth are established. Australia, Brazil, and a few others are exceptions, aiming for inflation between 2% and 3%, or even higher than 3%. Now, what happens if inflation moves away from the target? If it deviates downward, and prices slow down, then the central bank adopts an expansionary monetary policy: it injects cheap money, interest rates decrease at all levels, and more money circulates. And, according to the law of supply and demand, the value of the currency falls. If inflation deviates upward, and prices rise, the central bank adopts a restrictive monetary policy. Loans become more expensive, less money circulates, and the supply is restricted. And, according to the law of supply and demand (again), the currency's value rises.

The Indirect Impact of Inflation

While the direct, or almost direct, impact described earlier is based on incontrovertible logic and numbers, the same cannot be said for the indirect impact. The link, in this case, becomes more hazy, less stable, and more subject to countless external factors. Yet it is absolutely true: inflation also has an indirect impact on the currency market and, therefore, on the value of currencies. The basic principle that justifies this statement is not even that complicated: a country experiencing a strong moment of difficulty on the price front is judged as unreliable, less able to respond to the challenges of the present, and is therefore progressively abandoned by investors. By all types of investors, even those in Forex Trading. So, if a country has inflation that is too high or too low, its currency will lose value. Conversely, if inflation moves toward the target, the currency appreciates. Obviously, the impact of inflation must also be evaluated in light of other economic data, such as GDP, employment, and production. In the end, everything is interconnected. In reality, the impact, whether direct or indirect, is not always detectable. It can happen that the publication of inflation data goes unnoticed and has no effect on Forex. It often happens, but only under one condition: that at that particular historical moment, prices do not represent a problem, as they are stably positioned in the desired range, which gravitates (with the exception of countries like Brazil and Australia) around 2%. However, this is not the case at the moment. Almost everywhere, as a legacy of the now-past economic crisis, inflation is subject to distortions. This is certainly the case in Europe, which is struggling to reach the much-desired 2% despite the ultra-expansionary monetary policies implemented by Mario Draghi's ECB.

The Short-Term Impact

Inflation is an important but complex subject when studying its correlation with the Forex market. This is also because there is not only the dichotomy between direct and indirect impact but also between short-term and long-term impact. Perhaps this type of differentiation should be of greater interest to Forex traders. Inflation has a short-term impact and should therefore be taken into consideration by those who keep their positions open for a limited time, and even by those who engage in intraday trading. From this point of view, inflation behaves exactly like a medium-high power market mover: in the immediate term, it is disruptive (but only if the condition of "flat calm" described in the previous paragraph does not occur). When inflation data is published, the price reacts immediately, and the market already discounts the "real" effects of a change in prices in the short term (which are often reduced to the manipulation of interest rates in a specific direction by the central bank). In the very short term, however, when inflation proves to be lower or higher than necessary and thus moves away from the target, the currency tends to react negatively and depreciate. If, on the other hand, inflation is better than expected and thus takes a decisive step forward on the path toward the target, then the currency reacts positively and appreciates. It is worth repeating that this happens regardless of the direction. Inflation can increase or decrease, but everything depends on whether it is approaching or moving away from the objective.

The Long-Term Impact

The long-term dynamics of inflation are much more complicated, also because they involve elements of a purely technical nature. It is difficult, in reality, to predict not the "how" of the impact, but the "when." The market will also discount good or bad inflation in the long term, but it will do so, precisely, over a long time and perhaps in a less predictable, more dispersive manner. In any case, in this instance, what matters is not only the path of approaching/moving away from the target but also the direction. If inflation is too low and thus moves away from the target, the central bank will adopt an expansionary policy, and the currency - but it will do so in the long term - will depreciate. This happened with the euro a few years ago. It is useful, to clarify our ideas a bit, to revisit this case history. In January 2015, prices in the Eurozone reached their lowest point: -0.6%. From that moment, the ECB undertook a strongly expansionary policy. Well, what happened in the medium to long term? The euro depreciated, precisely because of the effect of this policy (which was already expansionary and was "only" exacerbated, and in fact, the single currency was already on a downward trend, albeit less steep, for a few months). It took less than two years, and the euro depreciated (against the dollar) by about 20%, almost reaching parity. What we described in theory earlier happened: a too-low inflation was followed by a depreciation of the currency in the long term. If inflation is too high and thus moves away from the target, the central bank will adopt a restrictive policy, and the currency - again in the long term - will appreciate. These are the movements, and they should be taken into consideration especially by those who trade over the long term or those who practice swing trading. In any case, after many decades of monitoring and shared history, the impact of inflation on the currency market is a fact. Examples prove it. Too bad the matter is very complex and, as we have seen, full of nuances.