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Economic indicators and their impact on currencies

Economic indicators measure how strong an economy of a country is. They can measure specific sectors of an economy, such as the housing or retail sector, or they give measurements of an economy as a whole, such as GDP or unemployment.

Traders are interested in these measurements because they have an impact on the value of a currency.

The following will explain two of the most important economic indicators that drive the value of a currency: interest rates and inflation.

Interest rates

Interest rates are one of the most important drivers of the forex markets. The base interest rate of a country is set by its respective central bank. It is used by a central bank as a tool to manage the economy – either by raising the interest rate to curb inflation, or lowering the interest rate to promote growth.

Changes in the interest rate affect borrowers

Raising the interest rate curbs inflation and lowering the interest rate promotes economic growth.

The mechanism behind using the interest rate as a tool works in the following way:

The central bank of a country lends money to certain banks and the base interest rate is what these banks have to pay for borrowing that money. Banks also lend money to other banks and consumers in the form of loans, who also have to pay interest – the minimum interest they have to pay is the base interest rate.

If the central bank increases the base interest rate, then borrowers have to pay more for the money they borrowed. This reduces the amount of money they have for spending on other things and thus impacts the economy.

An example using mortgages

For example, if the interest rate increases, those that have a mortgage may find that their monthly payments will rise.

Increasing the interest rate therefore results in curbing economic issues such as excessive inflation, because if people have to pay back a higher mortgage amount each month, they will not have as much money to spend on other goods and services.

On the other hand, if a central bank is concerned that the economic growth of a country is too low, then lowering the interest rate will lower the payment on these mortgages. People may therefore have more money to spend each month and this stimulates the economy.

Using interest rates in this way is not specific to mortgage payments. Companies that borrow money to grow, by investing or hiring new employees, are also affected. If companies have to pay back a higher amount because of higher interest rates, then this will curb the amount of money available for such investment.

Impact of the interest rate on the currency

Firstly, higher interest rates indicate a strong economy and investors are more likely to invest into an economy that is growing. The demand for local currency is therefore likely to increase, which leads to an increase in value.

High interest attract capital and so higher interest rates increase demand for a currency and the value rises.

A higher interest rate also means that you get a higher rate of return for the capital you hold in bank accounts. Investors will likely invest capital into countries that have a higher interest rate, because they are likely to get a higher rate of return for holding their money there.

Higher interest rates therefore increase the demand for the currency of a country and so it appreciates in value (under normal economic circumstances).
Inflation

Inflation measures how quickly the prices of goods and services rise in a given period of time. An increase in the inflation rate means that prices are going up more quickly. If the inflation rate falls, the prices of goods and services still rise, but at a slower rate.

If the rate of inflation increases, then the disposable income people have to buy things with is reduced more quickly. This can have a negative effect on an economy and hence the currency.

Inflation measures how fast or slowly the price of something rises. If the inflation rate falls, the price still rises, but at a slower rate.

However, if a country experiences deflation, i.e. prices actually fall, investors could also see this as an indicator that the economy is performing poorly. Therefore, this can also have a negative effect on the value of a currency.

Central banks tend to target a specific rate of inflation

A central bank will therefore try to target an acceptable level of inflation – for example, an inflation level between 2–3%.

If the inflation rate is reported to be within the target range, the currency value does not tend to react very much. The currency value reacts much more if the inflation rate is drastically outside this range.

Inflation can cause price fluctuations on a currency, although how it does so is less clear than other indicators. A high rate of inflation can cause a currency value to rise, because traders may anticipate a rise in the interest rates. However, an inflation rate that is too high can be a detriment to the economy and so currency can fall.

To protect consumers from excessive inflation, central banks will tend to raise interest rates. This is because, as explained above, it reduces the spending power that consumers have, and so the prices for goods and services decrease under the reduced demand. Under decreased demand for something, the price falls (or stops increasing).

When inflationary data is higher than expected, traders may buy the currency of a country in anticipation of an interest rate hike from the central bank, which means that the currency could appreciate in value. However, this depends, because excessive inflation could erode the value of any capital within that economy and the currency value could decrease. This makes the inflation rate a more difficult economic indicator to use when determining the likely increase or decrease of a currency value.

Hawkish vs. dovish

The terms ‘hawkish’ and ‘dovish’ refer to the attitude of a central bank toward managing the balance between inflation and growth.

If a central bank is concerned about inflation, it is considered hawkish and is more likely to adopt a higher interest rate. If a central bank is concerned about growth, it is considered dovish and is more likely to adopt a lower interest rate.

 

Summary

So far you have learned that:

  • economic indicators report on the strength or weakness of an economy.
  • traders use these reports to help determine the likely value of currency.
  • the interest rate set by a central bank is one of the most important drivers of a currency.
  • interest rates can be raised to curb inflation and lowered to stimulate the economy.
  • a higher interest rate usually results in an appreciation of a currency and a lower interest rate usually results in a depreciation of a currency value.
  • inflation measures the rate at which the prices of good and services rise over a given period of time.
  • central banks try to target acceptable levels of inflation. If the inflation rate falls outside of the targeted rate this can have a detrimental effect on the currency value.