An inflation hike will be experienced when a country goes through economic growth. Consumers normally suffer when this happens because the price of goods and services increase dramatically. Central banks globally have to face this situation on a regular basis and have developed methods to curb high inflation pressures. This may require monetary policy changes and transactions involving derivatives. These strategies undertaken by the central banks often result in curbing price rises. All these actions give forex traders a clear insight into the potential direction of forex price movements.
Interest Rate Adjustment
As soon as the central bank is faced with rising inflation, it normally opts for an increase in the interest rates. This is a simple and effective method and normally provides them with more effective results than other methods. This system increases the benchmark for retail and commercial bank loans to their clients. The immediate effect of this type of increase is normally on products such as corporate loans, student loans, personal loans, vehicle financing and mortgage loans. When interest rates are increased, it increases the cost of money and this affects both corporations and individuals negatively.
Investors are regularly looking for high return, low risk investments. The same applies to investors in the foreign exchange market. When countries increase their interest, the demand for that currency immediately increases due to investment interest.
This occurred when the Australian central bank made the decision to increase its interest rate regularly during the period 2009 to 2011. By 2011 this had caused the Australian dollar to increase in value compared to the US dollar by a massive 26%. The decision by the Australian central bank had increased the demand for its currency, especially against the US dollar. It was only once the global recession finally hit Australia that the central bank had to increase its interest rate to curb the increase in the inflation rate.
Foreign Reserves Adjustment and Foreign Exchange Rates
Another strategy that the central bank may make use of to stabilise their foreign exchange rates is to increase the banking community’s reserve requirements. This puts a limit on the money supply within a country. When the central bank increases the limit on this reserve, it is increasing the amount of cash the banking institutions should hold. This stops the banks from using all their available cash as loans. This restriction on the banks affects fund distribution which limits the money available in the economy to purchase the more expensive goods and services which puts a hold on price increases.
This method is one of the most effective to control the foreign exchange rates in a country. This decision often causes an increase the currency value to be increased which, in turn, creates a demand for the currency.
When the central bank adjusts the reserve requirement of the banks, the country is admitting that it needs to curb its inflation rate and is taking steps to do so. This affects forex trading speculation as traders wait for the next bout of adjustments. Once the money supply has started slowing because of the increased reserve levels for the banks, foreign exchange speculation will increase the currency value to increase and this will start a bout of inflation rate increases.