As a trader, you have two approaches by which you create a strategy for winning trades, which are fundamental and technical analysis. There is no doubt that technical traders are many because the approach is often useful in the short-term. On the other hand, long-term traders lean heavily towards fundamental analysis. The traders also deem fundamentals such as inflation and GDP data as the factors that are crucial to the growth of a given financial instrument. But the question is, what is the relationship between inflation and forex? What happens between inflation data and the value of a currency? What is the linkage? If you remain keen as you read the paragraphs that follow, these questions have all been answered. Inflation evaluates price changes of necessities in a given country. The word could also be used about rising prices of essentials in a country within a given time. Goods and services that often fall into necessities include medication, transport, and food. Inflation data is as critical to traders as it is to central bankers. Its calculation is mainly based on another measure called the consumer price index CPI. CPI measures the price difference of essentials in an economy over a defined time, often monthly. Inflation arises from the actions of central bankers, particularly money creation. It includes occasionally printing new banknotes and minting new coins to plug supply holes. However, money supply sometimes increases at a rate that is faster than that of economic growth, which is measured with the gross domestic product GDP. The consequence of this phenomenon is higher CPI, hence higher inflation. Inflation has a direct relationship with interest rates. This relationship happens at the instigation of central banks like the US Fed. The Fed, and all the other central banks globally, watch inflation rates closely because, as earlier noted, the entities are responsible for regulating liquidity levels in their respective economies. Central banks maintain a certain value, which is the upper limit of acceptable inflation. When inflation for a particular period exceeds the set target, the next logical decision is for a rate rise. More tools are available for the institutions to combat inflation, including money creation and open market operations. Low inflation will also force the central bank to act. Cheap credit soon floods the economy with money, which drives up demand for goods and services. As shown in the figure below, the US Fed has always cut interest rates during periods of economic recession. It is because economic recessions are often accompanied by low inflation. As explained earlier, inflation drives the interest rate decisions of central banks. Higher inflation indicates an overheating economy, to which the central bank responds by cutting interest rates. When the central bank manipulates the interest rates, the interest rate of one currency affects its value relative to rivals. It is what traders call exchange rates. Also, traders are looking to benefit from the carry trade. It means demand for the greenback will up. Increased demand will put upward pressure on the exchange rate between the USD and other currencies in pairs that include the USD. As is apparent, there is a high correlation between inflation, interest rates, and currency exchange rates currency market value. The economic situation in a country significantly affects the value of its currency. Consider a country — say the UK — that is going through explosive growth. This price increase does affect not only domestic consumers but also consumers in foreign countries.
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