Fundamentals: Inflation and currencies

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!

Inflation can be good for almost any currency as it will make the central bank increase the reference interest rate, offering more attractive interest rates on bonds and debt market for the foreign investors to move in. Also, higher inflation sometimes mean a higher rate of economic growth in the country with a higher yield on the invested assets, which results in more investments into the country.

As to your three points:

1) Emerging markets have higher risks and if the inflation increases that's also an additional risk factor, which is bad for their currency. Inflation in emerging markets can be significantly higher than 10%/year, which is quite bad for the foreign investments.

2) The PPP doesn't affect the currency market much. It's a nice concept that would work in some ideal world, but the currency market is affected by different forces. The effect of PPP is not that important, especially in short- or medium-term.

3) That also can be different but, generally, investors are "afraid" of high interest rates (result of a higher inflation) during the recessions, so inflation is not a big helper during the periods of recession. Unless, of course, you have some country with a booming economy, high inflation and high interest rates during global recession.

[quote=enivid;3177612]Inflation can be good for almost any currency as it will make the central bank increase the reference interest rate, offering more attractive interest rates on bonds and debt market for the foreign investors to move in. Also, higher inflation sometimes mean a higher rate of economic growth in the country with a higher yield on the invested assets, which results in more investments into the country.
quote]

OK, thanks for your answer! Very useful!

But I would still hold that, if you want to really, really single out the effect of inflation, you have to look at what the result is of high inflation all else being equal. And isn't that what PPP does? I agree that an (unexpected) increase in inflation many times means that the currency will strenghten, but the strenthening is not a result of inflation. It's a result of changed expectations to monetary policy - at least I believe so??

Just to check with you guys: this strenghtening is due to the markets' expectation that rates will likely be hiked more or sooner than otherwise expected? (I am asking these very basic questions to be 100% sure that I understand correctly, sorry)

Very intersting. I have also been exchanging a couple of e-mails with an instructor who teaches various subjects linked to financial markets. He gave me amongst other things, the following observation:

For example, China has been growing very fast, which led to high inflation and interest rates. But also for example, Germany has traditionally had a strong economy with low inflation and interest rates. Also, in a case like China this might lead to a weakening currency because of the high inflation, while in a case like Germany this would usually tend to lead to a strong currency.

So would you say that China is representative of emerging markets, like you described them, and Germany in this case could be the developed market? Do you agree with this observation? Other intersting cases to point out?

Thanks, this is useful for me, so I really appreciate it. I have already changed my view on inflation somewhat as a result of this thread.

Inflation can both lead to some factors that would increase the price of a currency and be an indicator of some process that leads to currency appreciation. I don't think that inflation can alone be a reason of the currency growth.

Yes, but China isn't a good example for currencies as 1) its economy is quite closed and 2) its currency rate is very regulated by the financial authorities and they try to keep it very undervalued (that's why by PPP yuan is very undervalued against the dollar and the euro).