Inflation — What Is It And What Does It Mean For The Stock And Currency Markets?

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News of the consumer price index (CPI) and personal consumption expenditure (PCE) rising to highs unseen since 1982 has triggered concern across North America. 

Murmurs of a long inflationary period have begun to surface, dealing a psychological blow to a world still reeling from the repercussions of a pandemic. On March 16, economic fears bubbled as the Federal Reserve announced its first interest rate increase in more than three years, a clear defense mechanism aimed at curbing inflation. The Fed declared plans for six more hikes in 2022 and three in 2023, ensuring an extension to those in the pursuit of life before the pandemic.

For something that has such a large impact on people’s lives, there can end up being little understanding of what inflation is, how it is curbed and its impact on different markets. Granted, inflation is a complicated subject, and even a basic understanding of it requires some mental commitment and research. But given its overarching influence on everyone’s lives, it’s a powerful concept in today’s world.

For companies with operations directly affected by it like FOREX.com, a broker in the U.S. and CA for foreign exchange (forex) markets, inflation presents a particularly interesting opportunity for traders and investors, especially when a connection can be established between inflation and its effects on currency markets.

Please be aware that past performance is not indicative of future results.

What Is Inflation? 

Inflation, in its most basic form, is a decrease in the purchasing power of money, which is reflected in the rise in the costs of goods and services.

Contrary to popular belief, inflation is not always a bad thing. Inflation can occur as a byproduct of a bustling economy, one in which consumers have excess cash and credit they spend regularly. The observation that products and services are typically cheaper in developing countries than first-world ones is, in part, a testament to inflation via economic growth.

On the other hand, inflation spurred by supply-chain issues, income polarization, labor shortages and government stimulus checks can end up serving as a potential threat to the health of the economy. The COVID-19 pandemic spurred all three of these inflation originators, causing prices to rise on a scale unseen in decades.

The entity responsible for controlling America’s money supply, and maintaining its inflation rate, is the Federal Reserve. The Federal Reserve’s main strategy for curbing inflation is raising the Federal Funds Rate (FFR). When people say “rate hikes” or “interest rate,” they’re referring to the FFR. An increase in the FFR means all kinds of interest payments, including mortgages, business loans, student loans and others, become more expensive.

The goal of the Fed is to raise the FFR to a point where spending money is naturally an adverse activity for businesses and citizens. This, in turn, decreases the supply of money in circulation, which tends to lower inflation and moderate economic activity. 

Inflation: Impact On The Stock And Currency Markets

It’s well documented that higher market interest rates typically have a negative impact on the stock market. When Fed rate hikes make loans more expensive, public companies relying on loan financing face a rise in costs. Over time, higher costs and less business could mean lower revenue and earnings for public firms.

Rising interest rates could be part of the reason why top performers like Apple Inc. AAPL and Microsoft Corp. MSFT faced a slump at the beginning of 2022.

In contrast to the stock market, raising the FFR typically makes the American dollar stronger. Part of the reason for this relationship is that higher yields attract investment capital from investors abroad seeking higher returns on bonds and interest-rate products. Specifically, if global capital flows are moving into dollar-denominated assets, chasing higher rates of return, the dollar strengthens.

A graph of the Federal Funds Effective Rate, outlined here, shows the relationship between rising interest rates and the value of the American dollar throughout time. For example, in the mid-1990s, when the Fed hiked rates, the dollar rose, and in 2002, the opposite occurred when the Fed cut rates. 

Inflation: How You Could Benefit

Understanding the relationship between the FFR and the American dollar can sometimes provide forex traders with an edge over other market participants.

The forex world is ruled by global interest rates, and the FFR is one of the foremost interest rates in the world. Remember, currencies rely on interest rates because they dictate the flow of global capital into and out of the country they represent.

While some forecasting may be needed for long-term holdings, announcements on global interest rates, like that made by the Fed a couple of weeks ago, may serve as excellent catalysts for traders, spurring volatility and movements across forex pairs tied to the American dollar and American economy.

For individuals looking at financial tools regarding inflation, FOREX.com reports that traders can take advantage of competitive spreads as low as 0.8 to trade recent and upcoming catalysts.

Learn more about FOREX.com here.

This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investing advice.

Please note that foreign exchange and other leveraged trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved, seeking independent advice if necessary

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