How do interest rates and inflation affect forex?

Why interest rates matter to forex traders

Interest rates represent the cost of capital; they are the fee paid by those seeking additional funds and the premium or reward earned by those providing the funds. These rates fluctuate based on macroeconomic conditions, the creditworthiness of those seeking funds, and the duration for which the funds are provided.

Interest rates are one of the key drivers of the forex market. Interest rates affect the exchange value in the forex market because the rates’ movements directly impact demand for a currency.

Differentials in interest rates, between individual economies, exert significant influence on the relative valuations of currency pairs and crosses. Whilst trends in, and expectations around the future direction of interest rates, directly affect trader sentiment and capital flows, within the Forex market.

International capital flows to wherever it can receive the highest returns, for an acceptable level of risk.

In Forex trading, that typically means that money flows to those currencies with the highest interest rates, particularly if those currencies offer positive real returns.

Real returns (as opposed to nominal returns) are generated when interest rates in an economy are higher than its rate of inflation.

Forex markets are sensitive to macroeconomic factors. Interest rates and interest rate policy are among the most important indicators in the macroeconomic hierarchy, whilst the rate of inflation is one of the biggest drivers of interest rate policy within an economy.

As such participants in Forex markets pay close attention to interest rate decisions and the comments made by officials who set interest rate policies.

Forex prices are dynamic and they reflect the sentiment and order flow, among traders in the market.

However those FX rates are not just priced for that moment, they also factor in expectations about interest rates and inflation out into the future. However, changes in interest rates aren't always guaranteed to move Forex prices and when they do move currency values it's often in conjunction with other factors such as the perception of an economy’s future strength and stability.

Traders in the Forex market will often reference the bond markets, and in particular, the yield curves within them, because those curves visualise what the market is thinking, and pricing in, as regards the future path of interest rates, and likely levels of inflation within a specific economy.

How central banks use interest rates

Central banks are state institutions which manage and implement the monetary policy of an economy. Monetary policy includes items such as the money supply, that is the amount of, and growth in the supply of cash, credit and other financial instruments within an economy.

Central Banks also set and manage interest rates, and interest rate policy, for their domestic economy.

They often manage monetary policy as part of a wider remit that is set for them by the government of the country.

Those mandates can require the Central Banks to keep macroeconomic factors, such as unemployment and the rate of inflation, at or near specific target levels. The bank will use its interest rate policy to try and achieve those goals.

If the Central Bank believes that financial conditions in the economy are too tight. Then it may lower interest rates, to encourage spending and investment in the economy.

Conversely, if the Central Bank feels that financial conditions are too loose, and there is too much money in the economy. Then the bank may raise interest rates to encourage saving and to make borrowing more expensive, thus removing money from the system.

Inflation, which can be defined as, too much money chasing too few goods and services, is a measure of price rises, however, it also measures changes in purchasing power and the level of excess demand within an economy.

The purchasing power or value of a currency can be eroded over time by inflation. The higher the rate of inflation, and the longer it persists, then the greater the erosion of currency values.

From a demand perspective, some inflation is a good thing, because it points to a growing economy.

However, it becomes problematic when the demand side of the economy runs ahead of the supply side's ability to keep up with that excess demand. And it's at this point that prices can rise dramatically.

The Central Bank sets out interest rates and interest rate policy, to try and create an equilibrium or balance within the economy. Such that the supply and demand for goods and services are closely matched and they often target a specific level of inflation.

For example, both the US Federal Reserve and the UK’s Bank of England have inflation targets at or around 2.0%.

Impact of interest rate changes on currency values

Higher interest rates offer the potential for higher returns to Forex market participants.

Money often flows towards those currencies with higher interest rates, and away from those currencies with lower rates of interest. Interest rates can be thought of as a measure of the rates of return from certain investments, for example government bonds, or cash held on deposit, in interest bearing accounts.

Forex is traded in pairs, that is a forex price is a reflection of the value of two currencies, relative to one another.

If we have a currency pair made up of currency A and currency B, and interest rates are higher and rising, in the economy of currency B, that currency will likely attract a flow of funds into it.

Those funds will enter currency B through the Forex market, as traders buy the currency.

Of course, if they are trading the A-B currency pair, then in buying currency B traders are selling currency A, at the same time.

The price of currency B should rise in the face of higher demand from buyers, whilst the price of currency A will likely decline, on the excess supply created by selling.

Examples of interest rate decisions and forex reactions

Forex markets often move when central banks make decisions on interest rates and inflation targets.

Currency values tend to move the most when major Central Banks announce significant policy changes.

One of the best examples of this type of behaviour can be found in recent history.

In March 2022, the US Federal Reserve raised interest rates for the first time since January 2019, as it sought to combat rising inflation. See this data from Forbes.

Before this point, the Fed had maintained low interest rates, of just 0.25%, to offset the effects of COVID-19.

However, by July 2023 US interest rates would stand at 5.50%.

The net effect of this extremely rapid rise in US interest rates, after a period of loose monetary policy, was to send the US dollar higher, with the dollar index rallying by +14.00% between March and October 2022.

How inflation rates affect currency strength

Inflation is a yardstick which is used to measure the rate at which prices are rising within an economy.

It is expressed as percentage and is measured over monthly and annual time frames.

Inflation can also be seen as a barometer for the level of excess demand in the economy.

The prices of goods and services will often rise when the level of demand for those goods and services exceeds the available supply.

As we noted above, inflation not only measures the rate of price rises within an economy but it also highlights the reduction in purchasing power in a currency, over time.

A rate of inflation of +10.0 percent per annum, in an economy, tells us that the purchasing power of that economy's currency is potentially being eroded by -10% annually.

Some of that erosion can be offset by interest rates, but if the rate of inflation is running higher than the rate of interest received on cash deposits, or the returns from other investments in the local currency, then there are negative real returns.

Continued erosion of the purchasing power of a currency, by inflation, means that the currency's value will fall on the foreign exchanges, and if high levels of inflation persist over the long term, then that fall in value can be significant.

For example, the current rate of inflation in Turkey (at the time of writing) is +71.60%, though it has been higher in recent times. Whilst interest rates in Turkey are running at 50.0%.

That means holders of the Turkish Lira are seeing the purchasing power, or value, of their currency being eroded by more than -21.0% per annum.

Over the last five years, the Turkish lira has depreciated against the US dollar by more than --500.0 %, according to data from Trading Economics.

If high rates of inflation go unchecked, a vicious circle can ensue.

As the government and central bank are forced to raise interest rates and print money to offset rapidly rising prices.

However, printing more cash weakens the local currency further, which in turn drives prices and inflation higher, and that necessitates printing of more cash, and so on.

In the worst-case scenario, the local currency becomes worthless as what’s known as “Hyperinflation” takes hold.

This is exactly what happened to Zimbabwe’s economy between 2007 and 2015, forcing the country to temporarily adopt the US dollar as its unit of exchange.

How interest rates and inflation interact

Inflation and Interest rates are interlinked through the monetary policy of an economy’s central bank.

Central banks try to control the level of inflation by loosening or tightening their monetary policy.

The central bank will raise interest rates and tighten its monetary policy if it feels that inflation is getting out of control and that the level of demand, and prices are rising too quickly.

On the other hand, if the central bank thinks that its economy is slowing down, it will try and stimulate spending and investment, by lowering interest rates and loosening its monetary policy.

Central banks eased their monetary policy in the wake of the Global Financial Crisis of 2008.

In some cases they cut interest rates to zero, or even lower, to dissuade investors and businesses from holding cash. Encouraging them to spend, or invest that money, back into the economy instead.

Monetary policy was also loosened in the wake of the pandemic and associated lockdowns.

However, as the global economy reopened, it became clear that inflationary pressures were mounting, and that prices were rising sharply.

At this point many central banks began to raise interest rates, to try and keep inflation under control, and ultimately squeeze it out of the system, if possible.

With US inflation having recently fallen to 3.00% from a high point of 9.10 % in June 2022, according to Trading Economics. The US central bank, the Federal Reserve, is now considering cutting interest rates once more.

What are the scenarios of high inflation and high interest rates and vice versa?

Inflation and interest rates often move together. Low-level inflation in an economy is not necessarily a bad thing.

It shows that the economy is growing and that the level of demand is running slightly ahead of the level of supply.

However, keeping inflation at benign levels is no easy task.

Particularly if there are supply-side issues in the economy, such as labour shortages, or a dependency on imports like energy.

These macroeconomic factors have a direct effect on global levels of inflation, interest rates and currency values.

Labour shortages became an issue post-pandemic, as workers sought different jobs or removed themselves from the workforce completely.

Whilst the Russian invasion of Ukraine, in February 2022, drove global energy prices sharply higher.

That combination pushed inflation up in most world economies, including those of the US, the UK and the European Union.

The Bank of England, the Federal Reserve, and the European Central Bank, or ECB, all raised interest rates to combat inflation, which in October 2022 hit 10.60% in the Eurozone, and 11.10% in the UK.

Eventually, higher interest rates, combined with improvements in the efficiency of the supply chain, caused inflation to fall from its peak.

It’s not just high rates of inflation that can be an issue, however.

In the decade before the pandemic, and the conflict in the Ukraine, many economies struggled with low levels of inflation and growth.

And there were even bouts of deflation and recession, where price changes, and rates of economic growth slipped into negative territory.

Central Banks cut Interest rates and kept them low, to stimulate inflation (growth) and in some cases, interest rates even fell below zero.

For example, the Swiss Central Bank, or SNB, kept its interest rates at -0.75% between January 2015 and June 2022. Despite this Switzerland experienced bouts of deflation in 2015, and again in 2020.

High rates of inflation accompanied by higher interest rates aren’t always a bad thing for a currency if the market believes that the central bank will do “what’s required” to get inflation under control.

Remember that higher interest rates can help to protect real returns for investors, which goes some way to explaining the strength of the US Dollar over the last four years, during which time, the dollar index has risen by +11.90%, against a basket of currencies from its major trading partners.

How Do Interest Rates and Inflation Affect Forex FAQ

What Are The Potential Risks and Considerations?

Outright changes in interest rates and rates of inflation directly influence Forex trading and currency values.

One of the biggest potential risks in pursuing Forex strategies that rely on inflation and interest rate differentials between currencies, such as carry trades, can come from a change in macroeconomic conditions or central bank policy.

For example an unforeseen pause in an interest rate hiking cycle, or a sudden and unexpected change in the rate of inflation.

Carry trades work on the premise that it’s possible to borrow money in a low-interest-rate currency, and then re-invest that money into a currency with higher interest rates, to generate returns.

However, if new information appears that makes the market think that those interest rate differentials will narrow. Then forex prices will adjust to reflect that, and the carry trade could quickly become unattractive.

Forex markets are forward-looking, to the extent that they price in expectations about the future path of interest rates and levels of inflation. That means they can pay less attention to headline inflation numbers and more attention to the rate of change or any change in direction.

Forex prices and currency values are also sensitive to perceived changes in monetary policy inferred by the wording of comments and statements from Central Banks and their key personnel.

These perceived changes can be very nuanced, FX rates can move on the inclusion or omission of just a few words or phrases in a Central Bank statement or a governor's speech.

This means that it is very easy for traders to find themselves on the wrong side of the market when Central Bankers are speaking, or making interest rate decisions.

Best Practices for Incorporating Interest Rates and Inflation into Forex Trading?

1. Start the trading week with a plan or map of what's coming up, and be aware of exactly when key announcements are due.
   Macroeconomic indicators such as unemployment, consumer spending, and economic activity surveys, can all influence expectations about levels of inflation and interest rates. Which in turn can feed directly into currency values.
2. Be aware of what the market is expecting from those data releases because data surprises move markets.
   Being informed about the consensus forecasts for, and the prior history of the release, means it should be possible to gauge the degree of surprise in the data, and the effect that will have on Forex prices and currency values.
3. Make use of freely available reports and tools.
   For example, the CME FedWatch tool provides traders with data and visualisations about the expectations of the future path of US interest rates and the data is broken down by each scheduled Federal Reserve meeting.

What Are The Regulatory Aspects of Forex Trading?

When you trade Forex with us, you’ll never take possession of any foreign currency. Instead, you’ll go long or short on a currency pair using CFDs.

Forex brokers are typically regulated in each of the jurisdictions in which they operate. For example,different regulators in the UK, Europe, and Australia are setting standards which all brokers under their jurisdiction must comply with. These standards include being registered and licensed with the regulatory body, undergoing regular audits, communicating certain changes of service to their clients, and more.

Regulations vary between jurisdictions, but there are some basic items that you should expect to find wherever you trade.

Such as segregated client money accounts, a KYC, or knowing your client and identification process, when you open a trading account.

Alongside formalised compliance and complaints procedures, which will include items like terms and conditions and execution policies.

What Are Tips for Maximising Knowledge of Interest Rates and Inflation?

To maximise knowledge of how interest rates and inflation affect Forex trading, traders need to stay updated about global economic news, central bank announcements and changes to key economic indicators.

The Pepperstone Macroeconomic calendar can provide a lot of this information. It covers data releases and announcements from across the globe which can be filtered by country and event impact.

Make use of reliable sources of information, such as financial news websites, and official reports from Central Banks and other organisations.

Reading regularly updated forex analysis (such as that provided by the team at Pepperstone) and participating in online forums or communities to exchange knowledge and insights with other traders, can also help to increase understanding.

Getting to grips with macroeconomic concepts, including monetary, and fiscal policy, will help traders gain a better understanding of the relationship between interest rates, inflation, and currency values.

This knowledge should help with the interpretation of economic data and anticipating potential market moves.

Additionally, practice analysing historical data and charts to identify trends and patterns in currency price movements. Using a combination of fundamental and technical analysis techniques could enhance the ability to forecast market trends and make more informed trading choices.

However it's still possible to lose money trading Forex even using analysis. For example, it's possible to have the right idea, but then get the timing of the trade wrong.