Forex Trading Basic

Fundamental Analysis: Inflation Rates

News Trading Strategies

Fundamental Analysis of Inflation Rates: The erosion of the buying power of money is called inflation. With the arrival of paper currencies and the authority of central banks to lower interest rates and print at will to increase the money supply, paper currencies as a form of money are always going to burn or corrode in value. The result is long term enhancement, irrespective of the short term supply that demand forces on the different goods and services within a country’s Consumer Price Index (CPI), the popular measure of enhancement.

 Though, different currencies burn at different rates of speed, depending on level of each countries active handling of interest rates and printing presses, and as traders is paying attention in the different burn rates. We are mostly interested in the rate of erosion of the purchasing power of the one currency against the other that makes up the join up.

Fundamental Analysis of Inflation Rates : Impact on Forex and Economy

High inflation rates in an economy decrease demand for the investments because all of or part of any expected asset yields can be erased by the level of inflation. For example, an investor would be foolish to invest in a 5% per year connection yield of a country that is undergoing 6% inflation as he would be losing 1% per year. Central banks keep seeing on the consumer price index to see if the inflation remains in good standards or is going up too much. They will potentially raise the interest rate if they think that the inflation rate has moved above the adequate levels.  Over and over again they will low the interest rate when they see that inflation levels are held in reserve and the economy is in the dejection.
For traders, the rule of thumb is given below:

Inflation RateCurrency Effect (Long Term)Currency Effect (Short Term)Short Term Reason
Higher Rate Weakens currencyStrengthens currencyTraders might this surging inflation data from the perspective of a central banker so worried about it that he needs to raise interest rates to control it.  Raising interest rates in turn strengthens the currency.
Lower RateStrengthens currency Weakens currencyTraders might see this from perspective of a central banker who now feels more free to lower interest rates or initiate new rounds of quantitative easing (money printing) in light of benign inflation data and a faltering economy.  Lower interest rates or printing money in turn strengthens the currency.

Ultimately, in long term a higher rate of inflation more quickly deflates the currency. That is so obvious in the short term a higher rate change in inflation can be positive for the currency. The reason for this is that traders will think that the central bank might raise interest rates to control inflation. Of course they will think wrong, and in todays globally devastated economy, central bankers are seeing the flagging GDP and being without a job as more pressing concerns than inflation. What will happen is that, if there is a lower than estimated inflation number, then it can give the central banker more freedom to lower interest rates, or if interest rates are already in the basement, to print more money,  in order to add lighter fuel to a struggling economy.

Comparison of Current and Historical Inflation Rates

One should first try to stare at the current situation in inflation rates within each pair, paying exact attention to the pairs that exhibit the greatest inflation rate difference. For example, below is a ranking of the major country’s inflation rates, courtesy of www.tradingeconomics.com:

Fundamental Analysis of Inflation Rates:

From the chart above one can clearly understant that the UK is major currency who are experiencing the greatest inflation rate of 3.4%, while Japan is experiencing the lowest at 0.1%, an inflation different of 3.3%. What its means is that it becomes difficult to justify being in a carry trade on GBPJPY when there is only a +0.5% positive interest rate differential that is almost completely erased by the -3.3% negative inflation rate differential.

Economic Calendar Events: Fundamental Analysis of Inflation Rates

Consumer Price Index (CPI)

  • Impact: Medium-High
  • Countries: US, UK, Japan, Switzerland, Eurozone, Leading European Countries
  • Frequency: Monthly

The most important event regarding inflation rates in the economic calender is the Consumer Price Index . The Consumer Price Index is a price index which tracks the prices of a specified set of consumer goods and services, giving a measure of inflation. Different countries publish their own changes to the Consumer Price Index, and traders look firmly to see the difference in forecast and actual rate for a short term trading opportunity, driving the internal currency up on a bigger than expected rate and driving it down on a smaller than expected rate.

Producer Price Index (PPI)

  • Impact: Medium
  • Countries:
  • Frequency:Monthly

The Product Price Index measures changes in prices in goods sold by the producer considered of low important, and the prices of products and raw materials purchased by producers, considered of medium importance. Since producers pass down very high costs to consumers it can be very valuable for early indicator of inflation and thus it gives the same short term and long term explanation as the Consumer Price Index.

Difference between forecast and actualCurrency EffectPossible
Trigger
Level
Potential
Pip
Range
Reason
CPI or PPI Higher than forecast ratePositive/bullish for currency+0.20%50 pipsCentral bankers might see the higher inflation rate as a threat that needs to be subdued by a higher interest rate
CPI or PPI Lower than forecast rate Negative/bearish for currency-0.20%50 pipsCentral bankers might see the lower inflation rate as a non-threat and so they can focus instead on keeping interest rates the same or lower.

Note that an increase in inflation has a bad impact on any currency. It is thus very ironic that traders will trade up a currency due of having a higher than forecast rate, but they are only doing so because they are seeing the different  rate change from the eyes of the central banker, who might be frightned enough by the higher inflation to speed up the interest rate in an attempt to curb it, and this speed up in interest rate  will in turn increase the demand for the currency.

Lately, as in the last ten years, central bankers have been more effective with lowering interest rates to fuel their flagging economies than the slowly upward  inflation rates that have internally disolve the purchasing power of most paper currencies. I would argue that in the big picture, the higher Consumer Price Index and Produce Price Index numbers are dangerous to the currency. The investors who are smart don’t want to invest in a currency that is more rapidly depreciating  and manufacturers don’t want to set up plants in a country where the costs of production are high. One of the reasons that the Yen has strengthen these last few years is that its almost “inflation free environment” has been seen as a safe place for investors fearful about the inflationary damage rate of most other paper currencies.

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Please note that: gaining profit from fundamental analysis largely depends on your brokers MT4 platform functions. If your broker is vulnerable to high slippage problem during the time of news release, you are not going to get expected result from trading. So, while Choosing Forex broker, we would like to recommend you to start trading with a broker that has slippage guard. We recommend you to trade with HYCM Broker to get the best possible outcome of forex trading fundamental analysis. Read review of HYCM Broker to learn more on this

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Chapter 6

Forex Trading Fundamental Analysis

Lesson 1.Forex Trading Fundamental analysis
Lesson 2Forex Trading Fundamental analysis
Lesson 3Fundamental Analysis of Interest Rates
Lesson 4Fundamental Analysis of Inflation Rates
Lesson 5Fundamental Analysis on Balance of Trade
Lesson 6Fundamental Analysis on Government Factors
Lesson 7Fundamental Analysis: Employment / Unemployment
Lesson 8Fundamental Analysis on GDP
Lesson 9Fundamental Analysis on Geopolitical Risks

Go back to Main Page: Forex Trading for Beginners

About the author

Syed Nazim

Syed Nazim is the Marketing Manager of RedMaroon, a Digital Marketing Agency for Financial Institutions. He is also involved with Forexing24.com as a writer and financial Analyst. He is a brilliant marketing geek with vast experience in every sector of Digital Marketing. He likes sharing strategies, tactics and proven methods to help you build a business and live the life of your dreams.

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