Inflation is inevitable. Any economy that sees growth will experience it, and consumers pay for it through higher priced goods. But what can be done about it? (To read more, check out, Fight Back Against Inflation.)
TUTORIAL: The Investor's Guide To Inflation
Plenty – when it comes to central banks. Global central bankers have had to deal with inflation and all sorts of other monetary forces through the years. In response, policy makers have had to increase the number of strategies for fighting inflationary pressures - from monetary policy changes (like higher interest rates) to derivative transactions. These strategies help to calm the rapid rise in prices when they are implemented, but they can also provide longer term clues for foreign exchange investors.
Raising the Interest Rate
Raising benchmark interest rates is the preferred plan of action when it comes to the central bank's fight against inflation. Why? It's the easiest and simplest strategy, and the results can sometimes be quicker compared to other methods. All a monetary body does, in this instance, is increase the benchmark that most commercial and retail banks refer to when creating client loans. These products include mortgage, student and car loans, along with commercial loans for businesses. Once these rates rise, the cost of money increases. This isn't a good thing for customers or companies. (For more on the relationship between interest rates and inflation, see Understanding Interest Rates, Inflation And The Bond Market.)
Foreign exchange investors are always on the hunt for this opportunity.
Global investors constantly search for high interest rate returns combined with relatively low risk. The same goes for foreign exchange investors. So, when a central bank elects to raise rates, you can be sure that demand for that currency will rise. For example, the Australian dollar benefited from this phenomenon beginning in June 2010. The central bank of Australia raised rates several times between late 2009 and early 2011. By January 2011, the Australian dollar had risen by 26% compared to the U.S. dollar in response, as shown in Figure 1.
|Figure 1: Higher interest rates boosted the Australian Dollar by 26% against the U.S. greenback in 2010|
|Source: FX Trek Intellicharts|
As the Australian economy rebounded quickly amid a slumping global economy, the country's central bank was forced to raise rates more than once – by 25 basis points each time – in order to fight inflation. The decisions led to higher demand for the Aussie, especially against the U.S. dollar, during that time. (For more information on the U.S. and Australian dollar, see Play Foreign Currencies Against The U.S. Dollar - And Win.)
Tweaking Reserve Requirements
An equally effective strategy for central banks is to raise the reserve requirements of banking institutions.
When a central bank elects to raise the reserve requirements, is limiting the amount of money or cash in the system - referred to as the monetary base. An increase in the reserve requirement increases the minimum cash reserve that a commercial bank is governed to hold, so this adjustment prevents the bank from lending out that cash. This restriction of money will slow the rise in prices as there will be less money chasing the same expensively priced goods (hopefully suppressing demand). The Chinese government favors this policy due to its own semi-fixed currency policy. Since the beginning of 2011, the People's Bank of China has elected to raise the reserve requirement three times – increasing the rate by 50 basis points each time.
The decision to raise reserve requirements should eventually slow down the inflation of a nation's currency. More often than not, such a decision also helps to fuel the foreign exchange rate's upward trend in value due to speculators. So, the central bank's decision holds significance for the foreign exchange investor.
By increasing the reserve requirement, the central bank is acknowledging that inflation is a problem and is aggressively dealing with it. However, this could increase a currency's attractiveness to forex investors, as they anticipate another round of reserve requirement increases. As the supply of money thins - a result of higher reserves held by banks - speculation helps to support and even propagate a higher currency valuation (thus lowering inflation). Referring back to the Chinese yuan, the effects of speculative demand are apparent: The currency gained by almost 4% following a series of reserve rate increases from June 2010 to January 2011, as speculators anticipated further reserve quota increases for Chinese domestic banks. (For more on the U.S. dollar and the Chinese yuan, see Why China's Currency Tangos With The USD.)
Open Market Operations
Global central banks also conduct open market operations to regulate money supply and ultimately control consumer inflation. Used by U.S. Federal Reserve officials, open market transactions are quite simple. Using their relationships with about 20 intermarket dealers, the Federal Reserve will transact in reverse repurchase agreements to temporarily reduce the supply of money or conduct overnight repurchase agreements to temporarily create supply. (To read more on how the Fed does, check out The Fed's New Tools For Manipulating The Economy.)
Yes, these operations do have an impact on foreign exchange rates as they are typically made in support of a longer term decision. For example, if central bankers are siding with an interest rate increase, they will subsequently be looking to use reverse repurchase agreements to further withdraw the system's money. As a result, foreign exchange investors will always be keeping an eye out for these announcements to ensure the current monetary tightening theme remains intact.
Last but not least, central banks will resort to simple currency appreciation in fighting consumer prices.
This strategy is typically used only by governments that offer fixed or pegged currencies, simply because they are able to effectively control the currency's exchange rate. The reason for this strategic choice is simple. Consumer prices typically rise as producer input costs - or raw material prices - increase. In order to mitigate higher producer prices, central bankers will allow a stronger currency to decrease the exchange-rated price of these inputs. This will effectively bring down consumer prices as producers pass along lower market prices to the customers.
For example, a barrel of oil priced at $100 a barrel will cost 700 yuan at an exchange rate of 7 USD/CNY. But if the yuan strengthens to 3 USD/CNY, the same barrel of oil will only cost 300 yuan. That's the equivalent of the price dropping to about $43 a barrel. (Read, Get To Know The Major Central Banks for more on central banks.)
Currency investors will see this as an opportunity. Fixed or pegged currency appreciation will only add to the underlying strength of the currency going forward. Why? Market demand will continue to outstrip supply as expectations of similar moves in the near term increase.
Singapore's economy adopted this policy in 2007-2008, as consumer inflation rose by an average of 6% and GDP grew by 10% during that time. Since then, the underlying currency (the Singapore dollar) has risen by 13% against the U.S. dollar. The Monetary Authority of Singapore widened the Singapore dollar's trading band in order to compensate for rising consumer prices. As expected, speculation of further flexibility in the trading band helped the country's currency to appreciate. (For more on the Asian markets, check out Introduction To Asian Financial Markets.)
The Bottom Line
By raising interest rates, increasing reserve requirements and applying up-to-date monetary tools, today's central banks have plenty of strategies to consider when fighting inflation. The timing and announcement of these strategies can present great opportunities for foreign exchange traders who are willing to keep their eyes on global monetary policy. (For further information, see The Currency Market Information Edge.)
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