Interest rates & Inflation

What is Inflation?
Inflation is a steady increase in the prices of goods and services. A pen that was $0.20 1950 years ago is $1 or more today because of inflation. One of the biggest influences on a central bank's interest rate decision is price stability, or "inflation". However, inflation at an acceptable level is good and in fact an indication of economic growth.

Economic impact of Inflation

Too much growth can raise inflation level to alarming levels. To keep inflation in check, the banks increase interest rates, resulting in lower overall growth and slower inflation.

This occurs because setting high interest rates normally forces consumers and businesses to borrow less and save more, putting a damper on economic activity. Loans just become more expensive while sitting on cash becomes more attractive.

On the other hand, when interest rates are decreasing, consumers and businesses are more inclined to borrow (because banks ease lending requirements), boosting retail and capital spending, thus helping the economy to grow.

Interest rates & the Forex market

A currency's interest rate is possibly the most important factor in determining the value of a currency in the foreign exchange market. Central banks are responsible for setting the interest rates and monetary policies in their respective countries.

Interest rates determine flow of global capital. Higher interest rates increase the demand of assets in the country, encouraging foreign investments, further strengthening the currency. Currencies surrounded by lower interest rates are more likely to weaken over the longer term.

Interest rate Expectations

Now we know that with change in interest rates in a country the value of the underlying currency is affected. Once the interest rate changes, the market factors it into the currency price. Hence from a trader's perspective, the "Expected" change in interest rate is what matters. Proper predication can reap high returns.

Rate differentials

The difference between the two interest rates is called the "interest rate differential", and can help identify shifts in currencies that might not be obvious. An interest rate differential that increases helps to reinforce the higher-yielding currency, while a narrowing differential is positive for the lower-yielding currency.

Instances where the interest rates of the two countries move in opposite directions is ideal for sharp swings.

Nominal vs. Real

Real interest rate = Nominal interest rate - Expected inflation

The nominal rate is usually the stated or base rate that you see (e.g., the yield on a bond) and is the interest rate that a central bank sets. However, markets focus on the real interest rate.

So if you invest money in a bond or put it in the bank for a yield/return of 5%, after factoring an inflation of 4% your real return is just 1%.

Forex Educational Articles & News

Top 5 factors that affect exchange rates ...

There are many factors that affect exchange rates of currencies. However some are more important in currency trading than others. These are; Interest and Inflation rates, Trade balance, Currency market speculation, Foreign investment and Central bank market intervention. Learn how to use these factors in your forex tra ...

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