Interest rates & Inflation

What is Inflation? Inflation is a steady increase in the prices of goods and services. A pen that was $0.20 1950 years ago is $1 or more today because of inflation. One of the biggest influences on a central bank’s interest rate decision is price stability, or “inflation”. However, inflation at an acceptable level is good and in fact an indication of economic growth. Economic impact of Inflation Too much growth can raise inflation level to alarming levels. To keep inflation in check, the banks increase interest rates, resulting in lower overall growth and slower inflation. This occurs because setting high interest rates normally forces consumers and businesses to borrow less and save more, putting a damper on economic activity. Loans just become more expensive while sitting on cash becomes more attractive. On the other hand, when interest rates are decreasing, consumers and businesses are more inclined to borrow (because banks ease lending requirements), boosting retail and capital spending, thus helping the economy to grow. Interest rates & the Forex market A currency’s interest rate is possibly the most important factor in determining the value of a currency in the foreign exchange market. Central banks are responsible for setting the interest rates and monetary policies in their respective countries. Interest rates determine flow of global capital. Higher interest rates increase the demand of assets in the country, encouraging foreign investments, further strengthening the currency. Currencies surrounded by lower interest rates are more likely to weaken over the longer term. Interest rate Expectations Now we know that with change in interest rates in a country the value of the underlying currency is affected. Once the interest rate changes, the market factors it into the currency price. Hence from a trader’s perspective, the “Expected” change in interest rate is what matters. Proper predication can reap high returns. Rate differentials The difference between the two interest rates is called the “interest rate differential”, and can help identify shifts in currencies that might not be obvious. An interest rate differential that increases helps to reinforce the higher-yielding currency, while a narrowing differential is positive for the lower-yielding currency. Instances where the interest rates of the two countries move in opposite directions is ideal for sharp swings. Nominal vs. Real Real interest rate = Nominal interest rate - Expected inflation The nominal rate is usually the stated or base rate that you see (e.g., the yield on a bond) and is the interest rate that a central bank sets. However, markets focus on the real interest rate. So if you invest money in a bond or put it in the bank for a yield/return of 5%, after factoring an inflation of 4% your real return is just 1%.

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• The role of central banks

• Monetary policies

• Interest rates 101

• Central banks you need to know