How interest rates move currenciesA central bank raises rates and the currency falls. This happens constantly, it is not a malfunction, and the reason is the single most useful thing to understand about macro trading.How inflation moves markets
Inflation fell and the market sold off. Inflation rose and shares rallied. Both happen regularly, and neither is irrational once you know what the number is being measured against.
Inflation is the rate at which the general price level is rising. If a representative basket cost $100 a year ago and costs $103 now, annual inflation is about 3%.
For markets the figure itself is rarely the story. What matters is what it does to expectations of central bank policy, and that chain is set out in how interest rates move currencies. This article is about the number: what it actually measures, and the four ways it is routinely misread.
Three words that are not synonyms
This is the most common confusion in economic commentary, and it is repeated by people who should know better.
| Term | What is happening to prices |
|---|---|
| Inflation | Prices are rising |
| Disinflation | Prices are still rising, but more slowly than before |
| Deflation | Prices are falling |
Inflation dropping from 6% to 3% is disinflation. Nothing got cheaper. Things got more expensive at half the previous speed, and the cumulative increase from three years ago is still there.
Real return: the number that actually matters
Nominal return is what the statement says. Real return is what it bought. The difference is the whole reason inflation moves asset prices.
A 6% return in a 4% inflation year
- Nominal return6%
- Inflation4%
- Rough approximation6% − 4%≈ 2%
- Precise calculation(1.06 ÷ 1.04) − 11.92%
Purchasing power gained1.92%The account grew 6% and bought 1.9% more. The subtraction shortcut is close enough at low inflation and drifts badly at high inflation. At 20% it is meaningfully wrong.
Headline and core
Headline inflation covers the whole basket. Core strips out selected volatile components, usually food and energy.
This is not a claim that food and energy do not matter - they matter enormously to households, and excluding them from an analytical measure is not a statement about their importance. The purpose is to see whether price pressure is broad and persistent or concentrated in things that swing wildly month to month.
So headline at 2.5% with core at 4.0% is a specific and awkward picture: falling fuel prices are flattering the top-line number while underlying pressure remains. A central bank looking at that does not relax, and a trader who read only the headline is positioned wrongly.
A single CPI release can beat expectations and miss them at the same time.
Base effects, which look like news and are not
Annual inflation compares today with the same month a year ago. That comparison point is doing half the work.
If energy prices spiked twelve months ago, that spike eventually drops out of the annual window. Inflation falls sharply. Nothing changed this month - the thing that changed happened last year and has just stopped being counted.
This is a base effect, and it produces headline moves that look like policy successes or failures and are neither. It is also why analysts watch the monthly figure alongside the annual one: month-on-month tells you about now, year-on-year tells you about now compared with a year that may have been very strange.
Why the same print moves markets both ways
Two releases. Identical inflation rate. Opposite market reaction, both entirely coherent.
Inflation 4%, market expected 5%
Four per cent is a high number by any developed-economy standard.
But it came in a full point under what was priced, which changes the expected policy path.
Traders reprice toward earlier and larger rate cuts.
Bond yields fall, shares rally, the currency softens, all on an inflation figure most people would call bad.
Inflation 5%, market expected 4%
Five per cent, and suppose it is down from six the month before. Inflation is falling.
It fell by less than expected, which reads as price pressure being more stubborn than assumed.
Traders reprice toward rates staying higher for longer.
Yields rise, rate-sensitive shares fall, the currency firms. On a figure that showed improvement.
In both cases the direction of inflation is the opposite of the direction of the market. The forecast is the hinge.
Where it lands, asset by asset
Bonds take it most directly. A fixed coupon is worth less when prices rise, so investors demand a higher yield, and higher yields mean lower prices on bonds already issued.
Shares split. Companies with pricing power pass costs on and defend their margins; companies without it absorb them and watch profits shrink. Separately, higher rates raise the discount applied to future earnings, which presses hardest on companies whose value sits furthest in the future.
Gold does not respond to inflation so much as to what inflation does to real yields - covered in trading gold.
Cash loses quietly. A savings account paying 4% against 6% inflation is losing about 2% a year in purchasing power while the balance goes up.
The markets inflation touches first
Commodities are both a cause of inflation and a response to it. They are also, conveniently, the most widely available non-forex market across our hundred broker records.
- 95of 100 brokers offer commoditiesEnergy and agricultural prices feed directly into consumer inflation.
- 60list metals explicitlyThe market most associated with inflation, and the one whose relationship to it is least direct.
- 32offer bondsBarely a third: the asset class inflation affects most mechanically is the hardest to access.
When a CPI release lands
Read in this order. Most people stop after the first line and trade on it.
- Actual against forecast: the surprise, not the level.
- Core as well as headline. Are they telling the same story?
- Month-on-month, which shows current momentum rather than a year-old comparison.
- Revisions to previous months, which can quietly reverse the last print's meaning.
- What moved in bond yields, which is the market's read on the policy implication.
- Whether the expected number of rate cuts or hikes actually changed.
Common questions
Does lower inflation mean prices are falling?
No. It means prices are rising more slowly. Falling prices are deflation, which is a different and much rarer condition.
What is core inflation?
A measure that excludes selected volatile components, commonly food and energy, to show whether underlying price pressure is broad.
What is a base effect?
A change in the annual inflation rate caused by what happened in the comparison month a year earlier, rather than by anything happening now.
Why did markets rally on high inflation?
Because it was lower than expected, which shifted the expected policy path toward easier conditions.
Does high inflation strengthen a currency?
Sometimes, if it leads markets to expect higher rates. Persistent uncontrolled inflation more often damages confidence and weakens the currency despite high nominal rates.
Is gold an inflation hedge?
Over long periods it has held purchasing power. Over months it tracks real yields far more closely than it tracks CPI.
What is a real return?
An investment return after adjusting for inflation. What the gain actually bought rather than what it was labelled.
What is stagflation?
High inflation combined with weak growth. It is difficult for policymakers because the standard responses to each make the other worse.
Why is the inflation target 2% rather than zero?
A small positive target gives central banks room to cut rates in a downturn and reduces the risk of tipping into deflation, which is harder to escape.
Ready to put this to work?
Our questionnaire ranks all 100 brokers against your own answers in about a minute - including, if it matters to you, filtering out the ones whose leverage and protections do not suit how you intend to trade.
Find my brokerBrowse all 100 reviews
Nothing here is financial advice. Leveraged products can lose more than they make.
Other relevant articles
How interest rates move currenciesA central bank raises rates and the currency falls. This happens constantly, it is not a malfunction, and the reason is the single most useful thing to understand about macro trading.
How to use an economic calendarIt will not tell you which way to trade. What it tells you is when the market is about to become a different market, which is more useful and much less often acted on.
Trading goldGold pays no interest. That single fact drives most of what it does, and it explains why the metal can fall on the day inflation comes in hot.