5-minute read
Here were are in the summer of 2022 and inflation is on the tip of most people's tongues. After decades of low inflation, prices are rising fast and it's causing a stir in financial markets, in Whitehall, and down the local.
In this article, we'll look at how inflation and currency markets interact – spoiler alert: it's not so straightforward!
What is inflation?
Let's get the easy-ish bit out of the way first...
The Bank of England defines inflation as "a measure of how much the prices of goods (such as food or televisions) and services (such as haircuts or train tickets) have gone up over time."
This sustained rise in the average price of goods and services is happening all the time, but it's only when it spikes beyond the normal 2% level, and especially when it accelerates faster than growth in wages, that we sit up and take notice.
What causes inflation?
There are basically two things that cause inflation: economists describe these as demand-pull and cost-push factors.
Demand-pull factors mean that demand is excessive compare to supply:
- High consumer spending could be caused by low interest rates which encourage cheap borrowing and greater spending
- Demand that grows quickly when resources are already fully utilised can lead to shortages, which in turn increases prices
- If the amount of money in the economy is not matched by the output of goods and services (called "excess money"), a situation where too much money chases too few goods occurs, leading to a rise in prices
Cost-push factors mean there's rising costs to production:
- Wages tend to make up a large proportion of a firm's total costs, so when wages rise, so do prices. When the two repeat and feed each other, this is called a wage-price spiral
- A rise in the cost of raw materials, such as commodities, leads to price rises
- Tax increases are likely to increase prices, too
How inflation built-up during the COVID-19 pandemic
- Global supply chains were stretched
- Worker shortages, port closures, and factory shutdowns contributed
- Lockdowns and testing regimes strained supply
- There was a major shortage of shipping containers and the ships that carry them
- And demand for space on container ships outgrew what was available
- Demand spiked after the initial pullback at the start of the pandemic
- Spending was fuelled by the furlough stimulus payouts and consumer behaviour
- Workers sat at home doing nothing, not spending except on "stuff" to be delivered
Isn't it all about supply and demand?
Most currencies are free-floating, meaning that exchange rates are free to move with changing supply of, and demand for, a currency. Floating exchange rates can fluctuate widely and are exposed to speculation, which can artificially strengthen or weaken a currency. However, compared to fixed exchange rates, which require central banks and governments to maintain a target rate by controlling interest rates and the buying and selling of the currency, floating exchange rates allow central banks and governments to use monetary policy to tackle other objectives (such as inflation).
Generally speaking and according to economic theory and history:
- Rising inflation tends to weaken a currency
- Deflation, or comparatively slower inflation, tends to strengthen a currency
Extended periods of low inflation should increase the purchasing power of that currency when compared to the currency of a country with higher inflation.
💡Consider also that low inflation in the UK means goods produced in the UK are likely to be cheaper than those produced abroad. Demand for UK exports might increase, increasing demand for pounds, further strengthening the currency.
So the idea is that rising prices causes the exchange rate to fall...
...What about falling exchange rates causing rising prices? This is where we currently find ourselves – the pound has dropped in value by around 10% since the start of the year causing import prices to rise and fuelling domestic inflation.
Inflation is being caused by a depreciation of the currency!
With a vast currency market made up of huge numbers of investors, speculators, traders, hedgers, banks, and businesses trading FX, I would argue that exchange rates are influenced less by real money flows (trade in goods and services) and more by trade in currencies and financial markets themselves!
Harry Mills, Founder & CEO Oku Markets
What about interest rates?
Central banks use interest rates as a big blunt tool to control the money supply and influence aggregate demand in the economy.
Economics is about behaviour – central banks, when they turn the dial on interest rates, aim to control group behaviour enough to pull back demand and slow down the economy, allowing prices to stabilise. It works first on sentiment and confidence in the future – consumers make decisions to spend less because they see that interest rates are rising. As rising interest rates feed through to mortgages, rents, and debt, this forces consumer behaviour, so we can see it's a fine tightrope for central banks to be walking – managing demand without crippling the economy!
Rising interest rates mean that foreign investors will receive a greater return for their deposits, so "hot money" flows will create demand for the currency. These flows of foreign money can be temporary and easily reversed when general market sentiment shifts, which is why economies prefer more long-term foreign investments.
Exchange rates are driven by many factors, and earlier I mentioned that it's becoming less about real money flows, and more about trading in the currencies themselves. This means that market sentiment is a major part of the puzzle, so the outlook for interest rates can have a huge impact on a currency's valuation, too! The prospect of aggressive rate hikes will likely lead to an instant appreciation in the currency!
Directionality and Volatility
I've spent most of this article talking about the direction, up or down, of a currency as it is impacted by inflation, interest rates, and market speculation. But volatility should also be considered.
We have an inherent feel for what volatility means and feels like, but it can be defined as the degree of variance in an asset's price over time. So if the pound goes up and down every day, despite never moving a great distance over time, we could call this fairly high volatility. Of course, it might also move a great distance whilst demonstrating high volatility.
Market volatility is generally caused by uncertainty and changing economic conditions. If central banks are adjusting interest rates, then financial markets will react. Stock markets generally speaking don't enjoy high interest rates (funding costs, mostly), and investors will look for ways of finding returns, such as in currencies, bonds, or commodities. So we can see how a higher interest rate environment can feed market volatility.
How to manage your currency exposure
Taking complex issues and distilling them to actionable insights for our clients is what we do best. We're proud to work transparently with our clients, and we work hard to break the asymmetry of knowledge and information in the FX market.
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
Thanks for reading 👋
