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Foreign exchange rates change in response to the different inflation rates in different currencies.

Understanding the Relationship Between Inflation and Foreign Exchange RatesARTICLE

By Tim Worstall

Readers who are financial business decision makers in the U.S. undoubtedly are familiar with the way markets tend to anticipate, follow and even react with some volatility to the Federal Reserve’s “forward guidance” about monetary policy. Forward guidance is what the Fed itself says about when and how it will raise or lower the target range for its federal funds rate, the goal of which is to maximize U.S. employment and achieve long-term inflation of 2 percent.1 What may be less apparent – but particularly useful to anyone managing international payments in multiple currencies – is the way in which inflation influences foreign exchange rates (and vice versa).

Inflation is defined as a rise in the general level of prices – in other words, an increase in the price of everything.2 Thus, it's not all that much of a surprise that inflation will affect foreign exchange rates. Exchange rates are, after all, simply the price of one currency when expressed in another. The price of a currency is included in those prices of everything, so in a sense it's simply one more price that changes as inflation rises.

Changes in foreign exchange rates can also affect domestic prices, thus influencing inflation rates – as various countries are finding out currently. The British pound has been falling against the euro and dollar, pushing up the price of imports and thus creating domestic inflation in the U.K.3 The Venezuelan Bolivar has fallen so far that the 100 bolivar note is worth less than its printing cost of 10 U.S. cents.4 Given that Venezuela is a major importer, this is aiding in driving inflation rates into triple-digit percentages.5

Higher Inflation Means Future Foreign Exchange Rates Will Fall

The economist David Ricardo, writing in the early 19th century (his magnum opus was published in 1817), formulated the “Law of One Price.” It states that traded goods should cost the same everywhere after accounting for transport costs (though nowadays we would expand “transport” and think of it as “trading” costs). If wheat is cheaper in France than in the U.K., then people will buy in France to sell in the U.K.; their trading activities will push up the price in France and reduce it in the U.K., until eventually the prices in both countries are the same.6

To understand how Law of One Price influences exchange rates, consider that the rise in prices caused by inflation only takes place in the currency which is experiencing the inflation. So, when there is inflation in France, wheat becomes more expensive in Euros, as do all other traded goods. People say that each euro buys less than it used to. Yet, the Law of One Price says that wheat should be the same price in Britain as it is in France – minus those trading costs. Thus, we expect the price of euros to fall when measured in pounds. In other words, the euro will fall in the euro-sterling foreign exchange rate as a result of inflation in France.

Turkey experienced a classic example of the relationship between inflation and foreign exchange rates a couple of decades ago. The country had a run of 30-to-50 percent annual inflation,7 and the Turkish lira’s foreign exchange rate fell by 30-to-50 percent each year against most currencies.8

Expected Inflation Changes Forward, Not Current, Exchange Rates

Markets are usually forward looking. So, for example, if people expect a stock price to fall in two weeks’ time they will sell in 13 days’ time to avoid that fall. The price therefore falls in 13 days, not 14. But then people anticipate this early fall, thinking, “Aha! Let's sell in 12 days’ time to avoid the 13 day fall as people sell” – and so on, until expectations of a future price fall become a price fall right now as people bring forward their action in time.9

However, this is not what happens to foreign exchange rates. Current (spot) exchange rates stay static in the face of expected future inflation. They may change due to other causes, but not because of inflation. For that inflation is in the future – our wheat price hasn't yet changed. So, if the fall in the exchange rate happened now, that would make wheat in France cheaper today, and we would have people selling pounds to buy euros in order to buy the cheap wheat. And if people sell pounds to buy euros, then that pushes the euro up in the euro-sterling exchange rate.

So, expected inflation is to some extent an oddity. It doesn't change spot foreign exchange rates; rather, spot rates fall in response to actual price changes. Forward exchange rates reflect expected inflation, but spot exchange rates don’t. Thus the pricing of a forward contract, which is an option to exchange euros for sterling in say, 12 months from now, will reflect the expected difference in inflation rates between the two currencies.

The Takeaway

Inflation can be viewed as a general increase in the price of goods and services or a decline in the value of the currency used to purchase those goods and services. A foreign exchange rate is the price of one currency in terms of another currency. Therefore, foreign exchange rates change in response to the different inflation rates in different currencies. But it is forward, not spot, exchange rates that reflect expectations of future inflation. Spot exchange rates reflect current prices, while forward exchange rates reflect prices after the effects of expected inflation.

Tim Worstall - The Author

The Author

Tim Worstall

Tim Worstall is a British writer on business and economics whose work has appeared in The Times, The Daily Telegraph, The Guardian, The New York Times, The Wall Street Journal and numerous other publications. He is currently a regular contributor to Forbes. His past business activities include exporting rare earths from Russia and producing video games. He is a Senior Fellow at the Adam Smith Institute in London.

Sources

1. “Release Date: November 2, 2016,” Board of Governors of the Federal Reserve System;https://www.federalreserve.gov/newsevents/press/monetary/20161102a.htm.
2. Definition of inflation, Investopedia; http://www.investopedia.com/terms/i/inflation.asp.
3. “UK consumer price inflation: Oct 2016”, Office for National Statistics;https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/oct2016
4.“Inflation-wracked Venezuela orders bank notes by the planeload,” The Wall Street Journal;http://www.wsj.com/articles/inflation-wrought-venezuela-orders-bank-notes-by-the-planeload-1454538101
5. Inflation And The Black Market Exchange Rate In A Repressed Market: A Model Of Venezuela, International Monetary Fund;http://www.imf.org/external/pubs/cat/longres.aspx?sk=44164.0
6. “On the Principles of Political Economy and Taxation,” David Ricardo;http://www.econlib.org/library/Ricardo/ricP.html
7. Turkey inflation: http://www.inflation.eu/inflation-rates/turkey/historic-inflation/cpi-inflation-turkey.aspx
8. Turkey currency exchange rates: http://www.tradingeconomics.com/turkey/currency
9. “Financial Markets Are More Forward Looking Than We Thought” , Royal Economic Society;http://www.res.org.uk/details/mediabrief/7673531/FINANCIAL-MARKETS-ARE-MORE-FORWARD-LOOKING-THAN-WE-THOUGHT-New-evidence-from-the.html

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