No doubt you will have heard a lot about inflation at the moment, as Australia continues to fall deeper into a cost of living crisis – like many countries across the world.

Fresh produce and fuel prices have hit the headlines, with inflation in Australia now at the highest point it has been since the financial crash of 2008.

This has all kinds of impacts on everyday lives. One area where it is keenly felt is the forex market, but you might be wondering how inflation can affect trading currencies. Well, let’s take a look.

What is inflation?

Inflation is a measure of the rate at which prices of goods and services rise over a certain time period.

The Consumer Price Index is used to measure those prices, with thousands of products and services split into 87 categories that are then assigned to 11 ‘baskets’ – or groups.

Those groups are:

• Housing
• Food and non-alcoholic beverages
• Recreation and culture
• Transport
• Furnishings, household equipment and services
• Alcohol and tobacco
• Health
• Insurance and financial services
• Education
• Clothing and footwear
• Communication

Comparing the prices of all of these items over the course of, for example, a year will offer an overall percentage – the rate of inflation.

What causes inflation?

There are two main causes of inflation: demand-pull and cost-push. Both are responsible for a general rise in prices in an economy, but they each work differently. Let’s take a look at them both.

• The two main factors that influence this kind of inflation are a decrease in the supply of goods or an increase in the cost of production. Increases in costs of raw materials and labour are also factors if inflation is cost-push influenced.
• Demand-pull can occur as a result of an economy growing either at home or overseas. Typically, however, it refers to the demand for goods and services increasing across four key areas: households, businesses, governments and overseas investors.

How inflation affects the forex market

Forex traders can often spot opportunities in trying to invest in markets that are going through periods of high inflation.

High inflation rates mean that the currency in question is generally devalued against others and can offer value to traders.

However, high rates of inflation also devalue the currency in its local market and can make foreign investors unlikely to hold the currency in large volumes – making it a much less attractive proposition for traders.

Finding the balance is key when looking to work with the volatile state of many currency markets.