I asked a very experienced FX trader, who trades on fundamentals a question about how inflation normally impacts the value of a currency.
I put it to him that currencies, all else being equal, should be hurt by inflation, and backed it up with the theory of Purchasing Power Parity:
”Inflation is the rate of change in prices. Inflation affects exchange rates directly via the balance of payments. If country A has persistently higher inflation than country B, but the exchangte rate between the countries does not change, then eventually, country A’s goods and services will be too expensive to export, while goods and services will be imported into country A from country B. The result will be an ever-worsening balance of payments for country A. Therefore, in the long run, country A’s currency must weaken. This idea is known as PPP (Purchasing Power Parity).
However, he came back with a more nuanced answer (via e-mail, and the answer was very brief. Unfortunately, I am not in a position to pump him for answers.)
He says you shouldn't generalise that much;
1) Emerging markets and developed markets react differently (But he didn't state how and why)
2) Especially countries with large imbalances on the balance of payments show very different tendencies (different to the concept of PPP? Not sure!)
3) Also, he says it depends on where you are in the economic cycle: are you entering recession, or are you in a growth phase? (Not sure if high inflation will support the currency if the economy is contracting - or expanding? And why?)
So anybody has some good input on 1, 2 & 3?
Thanks!
I put it to him that currencies, all else being equal, should be hurt by inflation, and backed it up with the theory of Purchasing Power Parity:
”Inflation is the rate of change in prices. Inflation affects exchange rates directly via the balance of payments. If country A has persistently higher inflation than country B, but the exchangte rate between the countries does not change, then eventually, country A’s goods and services will be too expensive to export, while goods and services will be imported into country A from country B. The result will be an ever-worsening balance of payments for country A. Therefore, in the long run, country A’s currency must weaken. This idea is known as PPP (Purchasing Power Parity).
However, he came back with a more nuanced answer (via e-mail, and the answer was very brief. Unfortunately, I am not in a position to pump him for answers.)
He says you shouldn't generalise that much;
1) Emerging markets and developed markets react differently (But he didn't state how and why)
2) Especially countries with large imbalances on the balance of payments show very different tendencies (different to the concept of PPP? Not sure!)
3) Also, he says it depends on where you are in the economic cycle: are you entering recession, or are you in a growth phase? (Not sure if high inflation will support the currency if the economy is contracting - or expanding? And why?)
So anybody has some good input on 1, 2 & 3?
Thanks!