Impact of inflation shocks on foreign exchange rates reflects central bank stature

J. Scott Davis and Pon Sagnanert

The buying energy parity (PPP) principle of alternate charges is well understood: A basket of products ought to have the identical worth in several markets when that worth is expressed in a typical foreign money. This assumes particular person alternate charges, absent market frictions, can freely modify to take care of parity.

Intuitively, the foreign money of nation A could be anticipated to ultimately depreciate towards nation B’s foreign money in response to higher-than-expected inflation in nation A. Buyers improve their expectations in regards to the long-run worth stage in nation A, and thus the foreign money of nation A should depreciate to make sure that the worth of a basket of products within the two international locations stays the identical when expressed by way of a typical foreign money.

Nevertheless, the connection between market-determined alternate charges and inflation shocks will not be easy within the quick run. In superior economies, alternate charges respect towards a basket of its main commerce companions’ currencies on days when higher-than-expected inflation surprises happen. This end result appears to distinction with what the PPP principle predicts.

Moreover, the correlations are combined in rising markets, suggesting that superior and rising markets reply in another way to information about inflation shocks (Chart 1).

Central financial institution coverage response impacts market habits

Economists Richard Clarida (Federal Reserve vice chairman in 2018–22) and Daniel Waldman offered a theoretical framework in a 2007 paper, “Is Dangerous Information About Inflation Good Information for the Trade Fee?” The authors try to elucidate how “unhealthy information” about inflation (higher-than-expected inflation) could be “excellent news” for the nominal alternate price (an appreciation) as traders contemplate how central banks may react to the upper inflation.

Empirically, they discovered vital variations in overseas alternate market response in international locations with formal inflation focusing on regimes, in contrast with international locations missing formal targets.

If traders consider that the central financial institution will react to an inflation shock by elevating the coverage price, then the shock won’t change beliefs in regards to the long-run worth stage, however it is going to alter expectations in regards to the coverage price within the close to time period. The upper rate of interest makes a rustic’s property extra enticing, resulting in capital inflows that respect the foreign money. If expectations in regards to the long-run worth stage are unchanged, there is no such thing as a purpose for the alternate price to depreciate to make sure PPP.

Thus, the response of the alternate price to an inflation shock ought to depend upon beliefs in regards to the central financial institution response.

N. Nergiz Dincer and Barry Eichengreen compiled a measure of central financial institution transparency, the place central banks are assigned a rating from 0 to fifteen primarily based on the readability of financial institution coverage targets and operations (15 being the very best rating on the financial coverage transparency index). We will examine the correlations in Chart 1 to those transparency scores to see if more-transparent central banks additionally are likely to have currencies that respect following an inflation shock (Chart 2).

The scatterplot exhibits a powerful optimistic relationship between the overseas alternate market response to shock inflation and financial coverage transparency within the cross-country pattern.

In different phrases, an alternate price tends to understand in response to an upside shock in inflation in international locations with higher financial coverage transparency, as markets consider presumed central financial institution response—the upper the transparency rating, the stronger the foreign money appreciation.

A regression of the correlation between an inflation shock and the alternate price on the central financial institution transparency rating has a coefficient of willpower (R-squared) of 0.48. Extra merely, the extent of central financial institution transparency explains 48 % of the cross-country variation within the correlation between the alternate price and inflation surprises.

The next stage of financial coverage transparency is one purpose superior economies’ correlations are typically optimistic, whereas some international locations with decrease scores expertise exchange-rate depreciation in response to a higher-than-expected inflation shock.

Drawing on one other indicator, market expectation of central financial institution response to an inflation shock could be inferred from the one-year-forward in a single day listed swap (OIS) price, a market-implied proxy for the place the coverage price might be one 12 months from now. Correlations between inflation surprises and the change in one-year-forward OIS could be instructive.

Chart 3 compares the correlation, calculated from 2010 to April 2024, between the inflation shock and the alternate price. It individually depicts the correlation between the inflation shock and the one-year-forward price.

For a lot of rising markets, the correlation of the inflation shock with the ahead price is simply as excessive as in superior economies, whereas the correlation of the inflation shock with the nominal efficient alternate price is far decrease. Thus, in superior economies, each ahead charges and the alternate charges have a tendency to extend in response to inflation shocks. However in rising markets, the ahead charges improve however usually are not essentially accompanied by an appreciation of the alternate charges amid inflation shocks.

In principle, a rise within the anticipated future coverage price ought to result in widened rate of interest differentials, all else equal. This is a crucial determinant of a foreign money’s power within the quick run.

However in some rising markets, by which the central banks are likely to have a decrease financial coverage transparency rating (which might suggest that the central banks’ inflation targets are much less credible), “unhealthy information” on inflation could also be perceived by market members as contributing to a rise in inflation threat premium, which could lead on traders to cut back exposures to the nation’s bond market, and a depreciation of the foreign money in step with the PPP principle.

Larger inflation setting influenced market response to shocks

A central financial institution response perform will not be static and infrequently will depend on the macroeconomic setting by which the central financial institution operates. Chart 4 assesses a rustic’s inflation efficiency towards its central financial institution’s goal, exhibiting the distinction between the typical month-to-month inflation (12 months over 12 months) and the central financial institution’s inflation goal. (In circumstances the place a central financial institution’s goal is a variety, we used the higher sure of the goal vary. We additionally excluded international locations with out formal inflation targets and a few outliers, similar to Turkey and Argentina).

With a couple of exceptions, inflation averaged close to or effectively beneath central banks’ inflation targets earlier than the pandemic, from 2010 to 2019. Because the pandemic (we used information from January 2021 by way of June 2024), 15 of 20 international locations skilled notably above-target inflation, and for the international locations with nonetheless below-target inflation, the gaps between common inflation and their inflation goal narrowed significantly.

Certainly, Chart 5 exhibits the correlation between the one-year-forward price and the inflation shock within the pre- and post-COVID durations.

In a lower-inflation setting earlier than the pandemic, many central banks, together with the Federal Reserve, appeared considerably insensitive to inflation shocks. Subdued worth pressures following the International Monetary Disaster had restricted upside inflation dangers. In the meantime, the coverage charges in lots of superior economies have been pinned at or close to the efficient decrease sure—primarily a 0 % coverage price. Thus, there was restricted room for coverage charges to react to draw back inflation surprises. Because of this, the correlations between inflation surprises and the one-year-forward price have been low and even destructive.

Nevertheless, this correlation has elevated notably for many international locations as their central banks launched into a coverage tightening marketing campaign, boosting charges to curb surging  international inflation throughout the pandemic. Larger inflation and a motion of coverage charges away from the efficient decrease sure has meant that coverage charges react extra forcefully to inflation surprises.

As inflation normalizes towards central financial institution targets, dangers to the inflation outlook and central banks’ response capabilities ought to develop into extra balanced (with each upside and draw back dangers). Thus, it’s possible that ahead charges (market-implied central financial institution response) and alternate charges will proceed reacting to inflation surprises, particularly when involving central banks whose inflation targets are deemed comparatively extra credible.

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