How Inflation Affects Currency Prices
While the current account balance can provide clues to long-term movements in foreign exchange, inflation (or the general rising of prices within a country) can be used to provide medium term direction.
In fact, rising or falling inflation within a country is generally the biggest factor in determining the current account balance in the first place.
Higher Inflation vs. Lower Inflation
In economic theory, it is generally agreed that a country with higher inflation will see a depreciation in currency in comparison to a country with lower inflation or deflation.
The basic principle is that when a country experiences higher inflation, the cost of that country’s products go up and therefore become less attractive to foreign buyers. That country’s trade balance will worsen, the currency will be in less demand and so the value of that currency will go down.
Purchasing Power Parity (PPP)
Another way to look at this dynamic is using what economists call the purchasing power parity model (PPP) between countries. This theory basically states that a unit of currency should have the same ability to purchase something (an identical product that is) from country to country, excluding transport costs and taxes. Inflation distorts this parity so whenever the model comes out of sync between two countries, the exchange rate between the two countries should adjust to allow equilibrium to return.
Consider, for example, a McDonald’s Big Mac that costs, say, $4 in the USA. If that same Big Mac costs the equivalent of $6 in Australia, the purchasing power parity model between the two countries is clearly out of whack. How can two identical products that cost the same to make cost more in one country compared to another?
The answer is that inflation in Australia has caused prices to rise across the board, so that a Big Mac there costs a lot more compared to a Big Mac in America. As a result, the country with the higher rate of inflation (Australia) should see its currency depreciate against the US dollar until the real price of a Big Mac is much closer between the two countries.
Medium-Term Outlook
The analysis of inflation may not help some short term traders time the markets, since these exchange rate distortions tend to last for long periods. It is useful to consider inflation though and inflationary data releases such as CPI can cause markets to move quickly when released.
In general, though, inflation tends to drive exchange rates over the medium term horizon. Those countries with higher inflation will likely see their currencies depreciate over the medium term, (even though they may also benefit from carry trade transactions). Whereas those countries with low inflation will likely see their currencies appreciate.
To get a better view on how prices are influenced by factors such as inflation, you can look at the Forex Time contract specifications for an overall view of what you should expect when you consider currency trading.
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