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The latest U.S. consumer price index (CPI) reading showed inflation rose 0.5% in January, which translated to an annual gain of 6.4%!
Here’s a look:
U.S. CPI Inflation in January 2023
Source: U.S. Bureau of the Labor Statistics
And here’s a detailed look:
Source: U.S. Bureau of the Labor Statistics
Inflation has been on top of every investor and trader’s mind of late and rightly so. It’s been on a rising spree over the last couple of months and even touched multi decade highs!
What’s more problematic is it has picked up pace again in the recent month.
How is the U.S. central bank – the Federal Reserve – addressing this?
By raising interest rates!
Here’s a look at how interest rates have been raised over the past one year…
Interest Rate Hikes in 2022
Interest Rate Hike in 2023 so far…
Because rising inflation could lead to many problems for the economy as well as consumers, the Fed wants to tame it. And it is planning to do so by hiking rates.
If it does that, the rate at which it lends funds to other banks increases. This could mean low borrowings from these banks and the consumers, and it ultimately leads to less money in circulation in the market. That’s one of the simple ways in which a central bank can try to bring down inflation rates.
But it’s not as easy-peasy as it sounds. There are many factors involved, and tinkering any one of them could have a cascading effect on the others.
So, to make it simpler, let’s focus on the effects of inflation on exchange rates.
To do that, let’s understand why the U.S. dollar (USD) has been strengthening since 2021.
The USD was in a downtrend since the start of the pandemic in 2020. But that has changed since the end of January 2021.
We saw a U-turn in the market and the USD broke its downtrend line to the upside, as can be seen in the chart below…
USD’s Rally Since 2021
How did this happen?
The simple answer to that is ‘inflation.’ As inflation rose, the dollar started strengthening.
The CPI has been climbing since 2021. Despite the cool off we saw recently, it’s still in an upward trend and is back at it in January.
This bears importance if you are a Forex trader.
One of the core concepts of Forex trading is understanding that inflation will affect interest rates, and interest rate expectations will affect exchange rates.
Higher Inflation = Higher Interest Rates = Stronger Currency
And this is evident from what we’ve been seeing in the last couple of months.
As the CPI started to move higher, the USD has been in an uptrend.
That tells us that as a trader, you have to look at fundamental inflation announcements in the economic calendar to plan your trades for potential profits.
A higher inflation reading will mean bullish sentiment for the market, while a lower reading will mean bearish sentiment.
Take the GBP basket for instance…
Suppose the market expects to see the inflation figure to come out at 0.5% for the U.K.. However, the actual reading comes out higher than that. In this case, we could expect the GBP basket to potentially strengthen during that trading session.
And that’s because of the same formula we saw above.
So, that’s one simple way to know which way the exchange rates are most likely to move during fundamental inflation announcements. And consequently place your Forex trades accordingly to targetcash in some potential profits.
Our pro analysts are closely monitoring these developments in today’s market. They’re predicting a major shift in USD pairs. Click here to learn about their forecast.
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Predicted movements expected to last through the end of Q1 2023.
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