The dollar continued to gain some traction as the pound eased in the wake of softer-than-expected U.K. inflation. While the inflation readings for the U.K. remained elevated relative to the historical norm and other countries, they dipped below expectations which helped ease the value of the pound versus the greenback. The decline in U.K. inflation took some potential tightening expected from the Bank of England out of the market. The pressure the Bank of England is under to rein in inflation is severe. The Bank of England has a single mandate of price stability, and with U.K. inflation higher than inflation on the continent and the United States, there is a keen focus by the central bank to reduce rising prices.

What is Inflation

Before we discuss how lower inflation has reduced the exchange rate of the pound relative to the dollar, it is crucial to go over the term inflation and how it impacts economic growth.

Inflation refers to the general increase in prices of goods and services in an economy over time. When inflation occurs, currency’s purchasing power decreases, as you would need more money to buy the same goods or services. The inflation rate typically measures the percentage change in the average price level of goods and services over a specific period. Various factors, such as increased demand, higher production costs, or changes in government policies, can cause inflation. Central banks often aim to manage inflation to maintain price stability and support economic growth.

High inflation can have both positive and negative impacts on economic growth. Initially, moderate inflation can stimulate consumer spending as people are encouraged to purchase before prices increase. This increase in spending can lead to increased production and economic growth.

However, high and unpredictable inflation can have detrimental effects on economic growth. When inflation is too high, it erodes people’s purchasing power, reducing their ability to buy goods and services. This scenario can lead to decreased consumer spending and a slowdown in economic activity. Additionally, high inflation may cause uncertainty, making it difficult for businesses to plan for the future and invest in long-term projects.

Inflation also affects interest rates. Central banks often respond to high inflation by raising interest rates to curb spending and reduce money supply. Higher interest rates can make borrowing more expensive, discouraging businesses from investing and individuals from taking out loans for big-ticket items such as houses or cars. Reduced investment and consumption can result in lower economic growth.

How Does Inflation Impact an Exchange Rate?

Inflation can have a significant impact on a country’s currency exchange rate. When a country experiences high inflation, its currency’s value may decline compared to other currencies. This is because high inflation diminishes the currency’s purchasing power, making it less attractive to foreign investors and buyers.

When a country’s currency loses value due to inflation, the cost of imports from other countries increases. This situation can increase the country’s trade deficit as imported goods become more expensive. It may also discourage foreign investment, as it becomes less profitable for investors to hold assets denominated in a depreciating currency.

Furthermore, inflation affects interest rates, which can also influence forex trading. Central banks may respond to high inflation by raising interest rates to control price levels. Higher interest rates can attract foreign investors seeking higher investment returns, increasing demand for the country’s currency and potentially strengthening its exchange rate.

The relationship between inflation and exchange rates is complex, and other factors, such as interest rate differentials, political stability, economic performance, and market sentiment, also play a role in determining currency values.

What Happens to a Currency When a Central Bank Raises Rates?

When a central bank raises interest rates, it can have several impacts on a currency. Raising interest rates makes it more attractive for foreign investors to hold assets denominated in that currency. Higher interest rates can offer them a higher return on their investments, increasing the demand for that currency and potentially strengthening its value in foreign exchange markets.

Higher interest rates can also discourage borrowing and spending. By making borrowing more expensive, a central bank aims to reduce inflationary pressures and cool down an economy that may be growing too quickly. This change can reduce consumer spending, investment, and economic activity, which could weigh on the demand for the currency.

The actual impact on the currency will depend on various factors, such as the market’s expectations, the size of the interest rate increase, the country’s economic fundamentals, and other global economic and geopolitical factors. It’s important to note that while interest rates can influence currency values, the relationship is not always straightforward, and currencies can be affected by a wide range of factors in the foreign exchange market.

Why is the U.K. Inflation Higher than Other Counties?

The Bank of England has increased rates in the U.K. from zero to 5% since the beginning of 2022. Despite these efforts, its inflation levels have remained elevated relative to other countries. The U.K. purchases a lot of energy, and the impact of higher natural gas and petroleum prices is taking longer to decline than expected. The introduction of energy support has taken time to be reflected in consumer bills. Unfortunately, when food and energy are removed, inflation remains elevated. Core inflation, which eliminates food and energy, is at a 30-year high in the U.K.

Inflation should begin to slow as spending declines. A closely watched survey has shown that kK economic activity slowed sharply in July as rising interest rates hit consumer spending and a manufacturing downturn deepened. The flash UK PMI services output index declined to a 6-month low of 51.5. The manufacturing output index hit a seven-month show that most businesses reported a contraction.

Why Did the Pound Decline Versus the Dollar

The pound returned some of its recent gains due to declining inflation expectations. The Consumer Price Index showed that U.K. inflation rose at 7.9% year over year compared to expectations that it would increase by 8.2% yearly.

UK CPI is a measure of inflation that tracks changes in households’ average prices of goods and services. The UK CPI is calculated by collecting price data for goods and services, including housing, transport, food, and clothing categories. It provides essential insights into the price movements in the U.K. economy and is widely used by policymakers, businesses, and consumers to monitor inflation trends.

Core inflation in the U.K. declined to 6.9% year over year compared to expectations that it would be 7.1% yearly. U.K. core inflation refers to inflation that excludes volatile components such as food and energy prices. It focuses on the underlying trends in inflation by excluding items that can experience significant price fluctuations. The U.K.’s Office for National Statistics calculates the core inflation rate by excluding certain items prone to short-term price movements. This measure provides a more stable and reliable indicator of inflationary pressures and is often used by policymakers to make monetary policy and economic planning decisions.

Interest Rate Differentials Move in Favor of the U.S.

The pound declined as inflation expectations dipped and expectations that the Bank of England might hold off on additional rate hikes immediately. The information moved the interest rate differential between the U.K. and the U.S., impacting the currency exchange rate.

An interest rate differential is the difference between interest rates in two countries or currencies. It represents the variance in the cost of borrowing or the return on investment between these two economies. The differential is typically the gap between the interest rates of two central banks’ lending rates or short-term government bonds. It can have significant implications for various financial activities, such as foreign exchange trading, carry trades, and capital flows between different markets.

In the context of forward rates, the interest rate differential affects the pricing of currency forwards. A currency forward is an agreement to buy or sell a certain amount of cash at a predetermined exchange rate on a future date. Market participants consider factors such as the spot exchange rate and the interest rate differential when determining the forward exchange rate.

If the interest rate in one country is higher than in another, the forward rate for the country’s currency with the higher interest rate may trade at a premium to the spot rate. This premium is known as a forward premium. Conversely, if the interest rate in one country is lower, a forward discount may exist. The forward rate adjusts in response to market expectations of future interest rate differentials, and this adjustment is reflected in the forward exchange rate.

The Bottom Line

The upshot is that lower-than-expected U.K. inflation helped reduce pressure on the Bank of England to continue to raise rates immediately. As interest rates in the U.K. eased relative to U.S. short-term interest rates, the exchange rate eased as the forward rates also moved in favor of the greenback. Inflation will continue to be the driving force behind the movements of the pound and the dollar.

(Above mentioned article is consumer connect initiative. This article is a paid publication and does not have journalistic/editorial involvement of DMCL, and DMCL claims no responsibility whatsoever)