How do interest rates and inflation affect forex?

What is ‘the interest rate’?

The interest rate is the overall lending rate in a country, which ties into the overall rate worldwide. A country’s interest rate is either the stipulated amount at which commercial banks borrow from one another, or the rate at which commercial banks may borrow from the central bank.

The most important interest rate is set by a central bank like the Bank of England (BoE), which affects all other interest rates in an economy. Central banks of very influential economies such as the United States, the UK and China will affect developing countries’ rates too.

Because interest rates play a central role in spending, central banks use them to influence the entire economy as they have a ‘trickle down’ effect.

If the rate is hiked, the increased cost of borrowing by banks is passed onto businesses and consumers who then pay increased interest rates on loans, which also constrains spending. If the interest rate is reduced, loans become cheaper to pay back and spending increases.

The interest rate is used as a tool to help control inflation and stimulate economic growth during periods of stagnation.

How do interest rates affect exchange rates?

Interest rates affect the exchange value in the forex market because the rates’ movements directly impact demand for a currency.

This is because interest rates are a measure of the rate of return on certain investments and savings. Due to the relative attractiveness of the interest rate, investors may want to move capital into or out of a country, which impacts the supply and demand for a specific currency.

However, it’s important to remember that the effect of interest rate changes on forex is never guaranteed. It also doesn’t happen in isolation, but rather depends on several factors such as the perception of an economy’s future strength and stability.

As exchange rates depend on the supply and demand of a particular currency, all factors that impact on either of these will affect the value of the currency. You should have this top of mind at all times when you conduct their analyses of the markets.

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The demand for forex when interest rates increase

When interest rates are increased, you can achieve a better rate of return on savings deposits, lending or government and corporate bonds.

In theory, money will move from currencies in economies with less desirable investment opportunities to a currency with better prospects, positively impacting its exchange rate. The flow of money will drive demand up for the preferrable currency, while the currencies experiencing less demand will depreciate. This will, in turn, negatively affect the exchange rate.

The demand for forex when interest rates decrease

When interest rates decrease, investors can expect a lower rate of return on savings deposits, lending or government and corporate bonds.

Again, theoretically, investors may find better opportunities elsewhere. This means the demand for that currency will fall, due to the fact that investment capital flows are diverted to more attractive investment destinations. This would depress that country’s exchange rate. It would also increase the supply of the domestic currency in forex markets and drive the price of the currency down further.

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What is inflation?

Inflation is the rate of increase in the cost of goods and services in an economy. The adjustment to inflation impacts the spending power of consumers, which has a spiralling effect on business’ ability to produce goods due to the spike in the cost of raw materials.

Inversely, when the price of goods and service decrease substantially, and the value of the currency strengthens, this effect is referred to as deflation. The central bank of the country is responsible for adjusting the level of inflation and uses the consumer price index (CPI) to measure the rate.

How does inflation affect exchange rates?

When inflation is high, the value of a country’s currency weakens. This is because goods become more expensive, and it becomes less attractive for investors to do business. The inverse is also true. When there’s significant lowering of inflation, there tends to be more flow of money in a country, the buying power of the currency becomes more valuable, and the exchange rate strengthens.

Why inflation causes interest rate hikes

The central bank raises interest rates to slow down economic activity because people have more money to spend. The inflation rate would have to be low for a country to experience a hike in interest rates. Low inflation stimulates movement of money, and an increase in interest rates encourages people to spend less.

What’s ‘balance of trade’ and how does it affect forex?

Balance of trade is the variance between a country’s income due to exports and its expenditure due to imports. Balance of trade can further be broken down into balance of trades for goods or for services.

When inflation drives up the price of goods and services within an economy, that nation becomes less competitive in the international marketplace, resulting in exporters losing ground to cheaper countries. This means that the ‘balance of trade’ is altered and demand for the currency declines. This in turn will affect the foreign exchange rate.

During times of high inflation, foreign goods and services become more attractive to consumers and businesses as they’re cheaper. This means that imports will increase. Consequently, this causes an increase in the currency supply in forex markets which results in a depreciated currency.

How to trade forex markets

When you trade forex with us, you’ll never take possession of any foreign currency. Instead, you’ll go long or short on a currency pair using spread bets or CFDs.

There’s a reason we’re the UK’s No.1 retail forex provider.¹ We offer more than 80 of the world’s most popular forex markets, including leading major, minor, emerging market, Australasian, Scandinavian, and exotic pairs.

To start trading forex:

1. Research your preferred market
2. Create a live account or practise on a demo
3. Click ‘buy’ to go long or ‘sell’ to go short
4. Take steps to manage your risk
5. Open and monitor your trade

Trade forex on the spot

Spot forex trading is buying FX ‘on the spot’, which means the exchange takes place immediately, at the exact point that the trade is settled.

When spot trading forex, you’ll buy and sell a currency pair at the current market rate, known as the spot (cash) price.

You can speculate on forex spot prices with us via spread betting and CFD trading. Spreads are usually lower than those available when trading FX forwards.

Trade forex forwards

The opposite of spot trading, forex forwards mean you’re buying or selling forex at a specified price on a predetermined expiry date in the future. This means you’ll be predicting in advance what that currency pair will be by a certain date still to come and will make a profit if your prediction is correct and a loss if it isn’t.

Like speculating on the spot, forex forwards can be traded using both spread bets and CFDs. While spreads are generally slightly higher for FX forwards, you won’t pay overnight fees to keep your position open longer than 24 hours.

Trade forex options

Forex options (also known as currency options) are derivatives that give you the right – but not the obligation – to buy and sell a currency pair on a specific date for a specific amount (known as the strike price).

FX options are popular because you- aren’t obliged to complete the purchase. Also, they offer limited risk when the trader is buying the currency pair, as they can only lose the initial amount, they paid to open the position (called the premium).
However, it should be noted that the risk is potentially unlimited when selling currency options. This is because the buyer can exercise the call and hold the position for a long time, which prolongs your losses. Despite the potential risk, your account balance will never fall below zero.

How do interest rates and inflation affect forex summed up

• Interest rates are the predetermined amounts by which banks may borrow from the central bank or each other
• Interest rates can affect exchange rates and cause volatility in forex markets, which may be seen as an opportunity for traders
• Inflation, the rate at which prices in the economy are rising, also affects the forex market
• You can trade forex with us using spread bets or CFDs. You’ll never own any currency outright, but will instead speculate on whether one’s value will rise or fall against another’s
• You can also trade FX on the spot, using forwards, or with options

Footnotes
¹ By number of primary relationships with FX traders Investment Trends UK Leveraged Trading Report released July 2024