The important effect of inflation and interest rates on the forex market
If you see a country has a high interest rates, your may assume that it will attract a lot of international money seeking high yields. But this isn’t the case.
The other thing a forex
trader needs to keep in mind is inflation. Inflation dampens down the effect of interest rates.
Let’s look at an example to show the effect of interest rates and inflation…
Imagine that in Australia interest rates are sitting at 6%. But the rate of inflation is sitting at 8%.
Forex traders want to know the real interest rate
This would put international traders off investing in the currency as they’re effectively losing 2% of their purchasing power. The real interest rate is -2%. (The real interest rate takes inflation into account.)
Forex traders know that if a currency falls in value domestically, it’s also likely to fall in value internationally.
So a country with high inflation can deter investors.
Let’s look at another scenario…
Say the interest rate in the Eurozone is 4% and the rate of inflation is 1%. This is likely to attract international traders as they can get a real rate of 3%.
A trader may think that despite a low interest rate, the purchasing power of euros isn’t falling as much as Australian dollars, so investing in euros makes better sense.
When it comes to currencies, interest rates can impact currencies over the short-term. And this is why you need to know when there’s an interest rate decision looming.
But determining the bigger picture is the real rate of interest. That is the interest rate less the inflation rate.
So there you have it. Why you need to pay attention to interest rates and inflation when you trade forex.
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