Inflation and Interest Rates

Hey guys, as you see I am writing on 15/06/2018 right after the ECB’s decision to leave interest rates unchanged and before the announcement of Eurozone’s CPI. The decision of ECB to leave interest rates unchanged resulted in a sudden fall in EUR/USD.

I know that higher inflation of the base currency usually leads to the rise of the pair, in this case EUR/USD, assuming that we are in a healthy economy and higher inflation is an indicator of a potential increase of interest rates by the relevant bank.

*However, I must say that since recently I thought that high inflation should potentially lead to the devaluation of a pair, by the law of supply and demand (if the supply of money in the economy increases, in this case EUR, then the value of EUR falls). So I would appreciate if someone explains what I am missing here as well :slight_smile: *

Anyway, in this case the order is reversed. The interest rate decision has first come out, and the inflation is being announced tomorrow. I was wondering how I should think about this problem in this case. How could each scenario of CPI announcement tomorrow influence EUR/USD?

What you saw was expected in that scenario, the US increased rates which strengthens the USD and supresses inflation, and Draghi did not raise rates, so you saw the Euro fall in relation to the dollar. The base currency EUR fell against the quote currency USD.

Hey basically I’ve read two contradictory opinions about how inflation affects the forex market.

The 1st is that if inflation rises --> money supply increases --> value of money depreciates
The 2nd is that if inflation rises --> investors expect central banks to raise interest rates to fight that --> value of money appreciates.

Also, my question was kinda reversed. In this case, we already know the decision about interest rates and we are expecting the announcement of inflation, not the opposite. Therefore, I was wondering whether the ECB already knows the CPI that is going to be announced, and since they know that it is going to be low, that could be the reason the kept interest rates unchanged.

Interest rate movements are an instrument used by Central Banks for several reasons and not just in reaction to inflation rate changes.

Iterative changes in interest rates can be used primarily to stimulate or contain economic growth regardless of inflation rate changes provided inflation remains within a pre-determined range.

It is not just an interest rate/inflation rate equation.

Thanks for your answer!