How does inflation impact exchange rates?

With the increase of inflation all around the globe, people started to wonder whether inflation would not affect only their purchasing power at home but also abroad through currency debasement.

While there is no definitive answer to how inflation differentials affect exchange rates in the short term, it is clear to say that sustained inflation in one country above other countries’ inflation rates will debase this country’s currency in the long term, provided there is no political and central bank will to put an end to it.

In this article, we are looking at details about how inflation can affect the exchange rate and the mechanisms to manage exchange rates despite economic differences, such as currency boards.

Why does inflation affect exchange rates?

Inflation is one of many factors affecting foreign exchange rates. Over the past decades, developed nations have seen continuous low-level inflation across the board, making it very predictable when dealing with foreign transactions, be it in US-Dollar, British Pounds or Euros.

Exchange rate fluctuations across these blocks were largely driven by economic factors such as growth differentials or financial demand, particularly for the US-Dollar during the financial crisis in 2008.

Inflation itself was more of a matter for dealing in emerging markets currencies. Still, this dynamic may change if inflation is persistent and central banks in developed nations do not act by raising interest rates in line with market expectations.

When looking at the impact of inflation, it is important to focus not on absolute inflation in a country but on the relative inflation between countries such as the U.K., where inflation is rising higher than in the U.S.

Relative inflation

Relative inflation is when the rate of inflation in one country is higher or lower than in another.

When the relative inflation rate of one country is higher than the other over a sustained period, and the central bank does not adjust for the relatively higher inflation by setting its interest rate to a higher level than in the comparable country, the base currency will likely depreciate over time.

In the past, many export-oriented countries had a deliberate policy of a weak currency to promote their exports, such as Italy, before they entered the Eurozone and gave up control over their monetary policy to the European Central Bank.

Currency boards and currency unions

In the current environment of very diverse inflation in the Eurozone, the European Currency Union is one example where relative inflation does not impact the exchange rate as the European Central Bank sets rates for all Eurozone members.

Inflation in the Eurozone runs as high as 22% in Latvia, while France’s inflation rate is a modest 6%.

On the other hand, countries with closed trading links to the Eurozone, such as the Czech Republic and Poland, have increasingly been forced to raise rates, with the Central Bank rate in the Czech Republic currently standing at 7% as a result of soaring inflation.

Bulgaria, an EU country, maintains a currency board with the Eurozone, with their currency, the Bulgarian Lev, being pegged to the Euro in a narrow trading band.

Due to the close links with the Eurozone, those countries can maintain relatively stable exchange rates versus the Euro. Inflation is expected to converge over time, and fiscal and economic policies are aligned through the EU.

Hence, it is unlikely that temporary higher inflation in those countries would significantly debase their currencies versus the Euro or cause a crisis in the Euro.

Persistent monetary inflation

Some countries, especially in Latin America, have persistently relied on sustained negative real rates and currency debasement in their domestic currency. As a result, their currencies are continuously declining as inflation expectations have been baked in.

As an example, the inflation rate in Argentina is currently running close to 100% year-on-year, with the Central Bank Rate standing at a staggering 75%. As a result of those significantly negative real rates, their currency declined greatly against all major currencies in 2022.

The reason for this is a lack of trust in Argentina’s political and economic leadership, which has suffered multiple defaults in the past decades and has consistently relied on printing money, capital controls and other forms of discouraging holders from trusting in the stability of the peso.

Other factors affecting FX rates

Inflation is only one of the factors, and often not the most important factor affecting FX rates. In general, rates are moved by a variety of factors; some of the most important are:

• Economic growth: When economic growth is strong, foreign investors are more likely to invest in the country, which increases demand for its currency, causing its exchange rate to rise. Conversely, when economic growth is weak, the demand for the currency will be weaker, which will cause the exchange rate to fall.
• Global trade: Exchange rates are also influenced by global trade. If a country has a higher demand for imports than exports, it will pressure its currency’s exchange rate downward. On the other hand, if a country has a higher demand for exports than imports, the currency’s exchange rate will increase.
• Government and fiscal policies: Government policies, such as taxation and spending, can affect exchange rates. Taxation increases the cost of doing business, which can reduce demand for a currency, resulting in a lower exchange rate. Conversely, excessive government spending may raise fears of fiscal instability, causing its exchange rate to drop, as witnessed in the decline of the pound sterling when Liz Truss took – briefly – office as Prime Minister last autumn.
• Monetary policy, capital flows and financial speculation: All those financial reasons can also have a major impact on exchange rates, sometimes the most pronounced, aside from the economy and government policies.

To sum up

While inflation is a grave concern for everyone in terms of the cost-of-living crisis, it is unlikely to play a major role in the foreign exchange market and relative exchange rates between major currencies unless a particular currency block would accept longer-term inflation by not adjusting their central bank rates in an attempt to reach positive real rates in the medium term.

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