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The Effects of Inflation on Your Forex Trades

By Alexander
In Guest Blogging
Oct 24th, 2012
0 Comments
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Understanding the relationship between inflation and interest rates can help you decide whether or not a particular currency is growing stronger or weaker and whether you should be buying or selling that currency. According to some experts at NASDAQ, the overall projected inflation rate in UK for 2013 is targeted at 2.2 percent. This is largely due to the volatility in energy prices. How this impacts you, as an investor, depends entirely on what currency you invest in and how inflation affects it. So, as always, it pays to do your forex research, whether you’re using an automated system or not, before you commit to a trade.

What is Inflation?

There are two commonly-held views about inflation. Once school holds that inflation refers to an undue expansion of a nation’s money supply. Other schools of thought define it as a general increase in the prices of consumer goods. In some ways, it’s a little bit of both.

forex inflation

As a nation’s money supply increases, and as money makes its way into the economy, current bank notes in circulation become diluted. This leads to the phenomenon of price inflation. There’s an increase in the supply of a currency, but not necessarily an increase in the supply of goods and services. In other words, there are more dollars chasing fewer goods and services so the marketplace demands a higher price for those goods and services. Forex traders need to be especially sensitive to this very real economic phenomenon.

Impact of Inflation on Forex

World currencies are extremely sensitive to price fluctuations. If a nation’s currency is inflated heavily, it lowers the total value of that currency. This makes the currency weak and a bad buy for forex traders. However, deflation isn’t always good for forex traders either.

Deflation is the process by which money is removed from the banking system through an economic slowdown or through taxation. If deflation is severe enough, the forex market might see this as a sign of a weakening economy entering an economic depression. While fewer currency notes in circulation means a higher value per bank note, it might also signal low aggregate demand in the marketplace. Persistent, but low, inflation rates might also signal the same thing.

How to Make Trades Based on Inflation Signals

Forex traders make money off of the volatility in the marketplace. Usually, it’s not so much the inflation itself that’s bad for forex traders but a significant deviation from projected inflation. Governments acknowledge inflation and publish data on it every quarter.

Forex traders look for rapid changes in the inflation rate, or deviations from earlier predictions. If inflation deviates from the expected rate and is higher than expected, it signals an economy whose purchasing power is quickly eroding. If the inflation rate is lower than expected, this signals a lack of demand in the marketplace and a possible depression or recession.

Forex traders should set firm buy levels and stop losses that take into account the expected rate of inflation. For example, energy prices are rising in today’s world economies. European nations are scrambling to figure out how to cope with a persistent recession.

If central banks decide to inject more quantitative easing into the economy, it may temporarily help the economy but it will ultimately result in an upward pressure on commodity prices, oil included. Forex investors then have to decide just how high oil prices can rise before it triggers an economic slowdown due to rising production costs. When it’s clear that an economic slowdown is imminent, it’s time to sell.

Conclusion

Forex investors should look to bonds and inflation when making investment decisions. Try to avoid being one of those traders who chooses to rely solely on algorithmic trading and pay attention also to the news and other fundamental factors. Regardless of whether you plan on using software or not, one thing you can’t ignore is the impact inflation will have on your profits.

Post contributed by Elizabeth Goldman

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