Inflation and FX?

What is the relationship between a country’s inflation and their currency? If inflation is high, does that automatically mean their currency will strengthen because the market believes the country’s central bank will raise interest rates?

The interplay between inflation and currency exchange rates is not straightforward.

For example, in the long run, high inflation should mean a weaker currency.

BUT in the short run, higher inflation could be either positive OR negative for the currency depending on whether the market believes that the central bank will address the higher inflation through interest rate policy (rate hikes) or whether the inflationary pressures are temporary and doesn�t necessarily require a policy adjustment.

To add to what Forex Ninja said, there’s also the question of the actual level of inflation. The US and EU are targeting 2% or lower, so even when supposed inflationary concerns arise it’s not really as if you’re talking about the type of inflation that is destablizing to a currency. That’s why those currencies often benefit from inflation talk. The situation is quite different in countries where inflation rates are double digit. In those cases, interest rates are often quite high, but still the currencies are weak.