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Inflation is one of the most important gauges for a currency trader to track, yet one of the more confusing pieces of data. A high inflation rate might normally be a bullish sign for one currency, but at the same time it could also be currency negative. Therefore, we layout a guide to understanding inflation and how it affects foreign exchange trading.

Inflation reports monitor the rise of the prices of basic goods and services in an economy, inversely the rate at which purchase power is falling. Think of it as a measure of how much you can buy with a dollar; e.g. if you can buy a quart of milk for $2, after a 2% inflation, that same quart will cost $2.04. The main cause for a higher inflation rate is a growth of money supply without an equal growth in the country’s assets; and most economists agree that a low and steady inflation rate is good for an economy, approximately 2-3% a year.

Inflation is measured by the Consumer Price Index (CPI) and Producer Price Index (PPI) reports. CPI measures the cost of a sample of goods and services on a consumer level, it’s considered the final stage of inflation; the higher the CPI, the higher the level of inflation. Core CPI excludes goods that are more volatile and whose price changes are less indicative of inflation, while seasonally affected CPI factors in the usual seasonal changes. The PPI measures what firms are charging each other for goods and services; it’s a look at upstream inflation.

An alternative to the CPI is the Personal Consumption Expenditure (PCE), which switches the specific goods and services that make up its sampling more often than the CPI. Therefore, the PCE is the preferred consumer inflation gauge for the Federal Reserve.

Additionally, the Institute for Supply Management (ISM) reports an index that measures the price paid by and received by firms. Oil prices should also be considered for clues to inflation, as higher oil prices may lead to higher inflation.

So, how does inflation impact the currency markets? Besides for a growth in money supply, inflation is also driven higher by low interest rates, because the excess money pushed by low interest into the economy drives prices up. Therefore, high inflation usually leads to the central bank raising interest rates, while lower than desired inflation rates can lead to lowering of interest rates. A higher interest might attract investors looking for a big return on their currency holdings, while a low interest rate currency might be sold for a better paying alternative.

However, the above process is only true when growth is generally good in the country’s economy; if growth is bad, high inflation can have an adverse affect on a currency. Poor growth coupled with high inflation can point to a recession, which could lead to interest rate cuts in the long run. Therefore, only trade on the assumption that high inflation will lead to high interest rates when the economic environment is stable or healthy. Otherwise, consider that the high inflation may hurt a currency in slow growth scenarios. That is why we refrain from automatically labeling an inflation reading as ‘better than expected’, or ‘worse than expected’.

Additionally, the interest rate you usually see is the nominal interest rate, which doesn’t factor in inflation. Markets focus more on real interest rates, which subtracts the inflation rate from the interest rate. So, high inflation can lower a nominally large interest rate when looking at the real rate, while deflation can add to a real interest rate.

Furthermore, always be aware of the central banks’ current sentiments about interest rate policy, and look out for news about members’ new sentiments following inflation changes. When reading news about a central bank outlook, remember that a hawkish sentiment means the bank member(s) want to fight inflation by raising interest rates, while a dove wants to keep interest rates low.

In summary, in a healthy economy, rising inflation likely points to higher interest rates, this in turn will favor the currency under discussion. However, in tougher economic times or in a slow growth period, consider all the factors mentioned above before placing trades based on inflation rate reports or expectations.