There has been a lot of noise around these topics recently as the world navigates economic uncertainty. The cause-and-effect relationship between these intrinsically linked factors is a complex one, however. In this article, we want to give you an overview of how interest rates, inflation, and exchanges rates tie together to give you an idea of how our dealers approach building a foreign exchange strategy for our clients.

What is inflation?

Inflation refers to a general price increase or a decline in purchasing power over time. It is measured by assessing the average price increase of a basket of selected goods and services that represent the diverse needs for living a comfortable life over a period of time. The most commonly used inflation indexes are the Consumer Price Index and the Wholesale Price Index.

What causes inflation?

Inflation rates are usually represented as a percentage to reflect the change in the index between two periods – either monthly or yearly. Inflation is caused by a faster increase in the level of money supply relative to wealth production, which is gauged by the GDP.

In other words, supply increases at a slower rate to demand.

Some inflation is healthy for an economy, as it shows increasing demand versus supply. But too much inflation can be a problem, as goods and services become less affordable. Central banks consider this when targeting an inflation rate; for example, the Bank of England has an inflation target of 2% as of 22 May 2020.

How does inflation affect foreign exchange rates?

A good general rule is that if inflation affects the foreign exchange rate, the effect is usually negative rather than positive. A very high inflation rate is highly likely to impact the country's exchange rates with other countries negatively. Inflation is also heavily linked to interest rates, which is also influence exchange rates.

What are interest rates?

We often think about interest rates as the 'cost of money.' It's given as a percentage of an amount loaned, which a lender charges to borrow money. Interest rates also refer to the amount earned from a savings account. In both these cases, interest is usually calculated on an annual basis.

Interest rates are set by a country's central bank, which they determine on a range of factors – like the state of the economy. Other banks and lenders will then use that rate to decide their own APR range.

Inflation and interest rates are intrinsically linked as central banks use interest rates to combat inflation. When the rates are high, the cost of debt rises, discouraging borrowing and slowing consumer demand. High rates also encourage saving, as people receive more money from their saving rate. On the other hand, low-interest rates encourage borrowing, as the rates are inexpensive. Low-interest rates often stimulate economies, but eventually, low rates lead to demand exceeding supply, which causes inflation.

Recently, we saw that banks are not beyond the effects of reduced demand brought about by high interest rates. The fall of Silicon Valley Bank and Credit Suisse was in part down to increasing interest rates, causing a slow in demand for its financial products. 

SVB had also bought a large amount of bonds when interest rates were low. Bond prices are inversely related to interest rates, so as rates go up, bond prices go down. SVB then had to sell a large amount of its bond holding to raise capital, making a $1.8 billion loss, this loss then spooked investors and so began the run on the bank

Inflation, interest rates, and currency exchange

The connection between interest rates, inflation, and currency exchange rates means we need to monitor all three for a more complete picture.

The complex relationship between them makes it difficult for countries to balance inflation and interest rates. Generally, low-interest rates positively affect the value of a country's currency. This is due to their encouragement of economic growth and consumer spending, although low-interest rates don't usually attract international investment.

However, if that spending leads to a situation where demand outstrips supply, it can lead to inflation. This will usually lead to central banks raising interest rates, discouraging consumer spending but attracting foreign investors. That, in turn, should lead to increased demand for the country's currency.

It is important to remember that attracting foreign investments is one thing; retaining them is another. If a country is seen as economically or politically unstable, or there is a chance its currency could devalue suddenly, investors aren't likely to hold the currency in large amounts or for long periods of time.

Other factors that can affect the value and exchange rate of a country's currency include:

• The balance of trade
• Economic growth
• The country's debt level
• The currency's perceived desirability

How will the anticipated inflationary increases affect the exchange rates of different countries?

The anticipated inflationary increases are only one of the economic indicators that investors monitor when determining exchange rates. This is because no single influence predominates continually. Economic growth may influence the rates until another factor, such as inflation or interest rates, significantly impacts the demand for a currency.

It’s important to remember when you consider interest rates or inflation and currency exchange rates, that they are all relative. A currency's value comes down to its domestic purchasing power and perceived value relative to other countries’ currencies.

For this reason, factors that can affect a country's exchange rate, such as inflation, can be influenced by other factors that might mitigate their impact. For example, Country A can have a rate of inflation that economists regard as high, but if that rate is lower than Country B's, then Country A's currency can be relatively higher than B's.

It’s the combination of these complex factors that make the foreign exchange market so volatile. At Moneycorp, we offer clients our insight and guidance to determine if there is a better strategy for approaching their foreign exchange needs. We aim to present our results clearly and precisely to help you understand the alternatives and leverage our expertise in a way that works best for you.

None of the information contained in this article constitutes, nor should be construed as financial advice. Moneycorp is a trading name of TTT Moneycorp Limited and is authorised by the Financial Conduct Authority under the Payment Service Regulations 2017 (reference number 308919) for the provision of payment services.