This is a sub-section that I forgot to include in my previous article that discussed inflation and financial assets. This is for a section of my manuscript that replaced two problematic sections. I kept this new section as lightweight and brief as possible; I might add more content later.
Currency trading is somewhat unusual in that the price reflects what is happening in two different currency zones. If we want to discuss how currencies relate to inflation, we should keep in mind that we should be talking about the inflation rate in the two currencies. For example, if the inflation rate in Canada is 2% and the inflation rate in the United States is also 2%, the effect of inflation on the Canada-U.S. exchange rate should cancel out.
For developed countries (with floating exchange rates), currency values largely reflect what is happening with capital flows, and to a lesser extent, trade flows. The problem with currency forecasting is that is like equity forecasting – there is very little to pin down the fair value of a currency in the short run. If currency traders suddenly decide that inflation data in one country is important, those reports will affect the value of the currency solely based on their mood.
In the longer term, trade competitiveness limits how far a currency can go in one direction or another. For example, if the Canadian dollar drops in value versus the U.S. dollar, Canadian wages will drop versus American ones in U.S. dollar terms. Sooner or later, Canadian businesses get more competitive than American ones, and so the Canadian dollar will get fundamental support from an improved trade balance, and/or investment inflows (both portfolio flows as well as direct investment).
Economists looked at simple macroeconomic models and decided that you can capture this effect by looking at the difference in inflation rates between countries. (Although the principle appears reasonable, we should probably be looking at a price index for traded goods.) For example, if Canadian inflation is 1% higher than in the United States, we are supposed to expect that the Canadian dollar will lose 1% in value in nominal terms versus the U.S. dollar (to aloe the same “competitiveness”). So, we end up with the concept of “real exchange rates,” where we apply the difference in inflation rates to the observed nominal exchange rate.
The figure above shows the real broad effective exchange rate for the United States (as calculated by the Bank for International Settlements – BIS). This is a broad exchange rate, which means that it is based on the exchange rates versus major trading partners, with a weighting based on trade volumes. We see that it does seem to bounce within a broad range (between 80 and 110). This may not be the case for a nominal exchange rate – if a country has sustained high inflation, its nominal exchange rate will just tend to get weaker over time. The figure below shows the experience for the Turkish lira after 2010 illustrating this, which reflects Türkiye’s higher inflation rate over the period. (Since the quote convention is the number of Turkish lira per 1 U.S. dollar, a higher number reflects a weaker lira – it takes more lira to get the same amount of dollars.)
Nevertheless, we see that the currency in real terms can march in one direction within the range for a long time (for example, the depreciation in the 2000s). This means that inflation alone was not explaining the change in the currency value. Which tells us that we cannot make strong predictions about the effect of relative inflation on a currency over the short run.
One reason why relative inflation is not enough to explain currency movements is that business cycles may not be perfectly coordinated. If a country is experiencing stronger growth than another, it would not be that surprising that it has a higher inflation rate. Although the higher inflation should theoretically reduce the value of the currency, the higher growth rates may attract inflows into local risk assets.
(If you read financial and economic commentary, people will often point to interest rate differentials as driving the value of the currency. They might argue that higher inflation will tend to result in the local central bank hiking the policy rate more than the other central bank, which will support the currency value. I think the role of interest rate differentials are wildly overestimated in such commentary, but that debate is tangential to this text.)
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