How interest rates impact currency strength and your cost of living

Economies worldwide are grappling with the ongoing fallout from the COVID-19 pandemic and facing record-breaking soaring inflation rates. The issue of rising inflation is complex and multi-faceted. One of the most common responses to inflation is for banks to hike up interest rates – but what does this mean for people day-to-day?

The Bank of Canada raised interest rates to 3.75% in the last week, to head off any potential spiking inflation. However, NDP Leader Jagmeet Singh asserted that the national bank’s role needs a further examination of its influence on the economy in general.

It raises major questions regarding how inflation and interest rates impact currency strength and individual cost of living. Here’s everything you need to know.

What is currency strength?

Currency strength is rated relative to other currencies. Strong and weak currencies have their pros and cons regarding the cost of imports and the value of exports.

Relative currency values are influenced by trade. Countries exporting more than they import have valuable currencies because of the high demand for their goods. High demand means rising prices and appreciating currencies.

Countries importing more than they export have less demand for their currency, which usually means declining prices at home. The national currency also grows weaker.

For example, if Canada is importing more of Product X from the US than it exports to them, Canada needs to buy more USD relative to the CAD sold. Canada’s demand for USD is higher than the US’s demand for CAD.

This means the value of CAD will fall. At the time of writing, one USD buys 1.36 CAD, meaning for every USD sold, 1.36 CAD is received in return. On the flip side, it costs 1.36 CAD to buy a single USD.

Impact on inflation

Countries with trade surpluses have more foreign currency flowing into the country, which can increase demand for that country’s currency, thus increasing its value on the currency markets.

One of the implications of trade surpluses is that they can lead to increases in inflation. Right now, every major economy is experiencing massive rises in inflation, which increases the cost of everyday goods on the ground.

Interest rates are designed to counteract this problem by artificially driving up the value of a currency.

Currently, inflation spikes have been driven by a massive demand for goods as countries emerge from COVID-19 lockdowns. The war in Ukraine has compounded the problem by limiting supplies of essential goods, including grain and fertilizer. In other words, we’re experiencing demand-driven inflation.

Cost of living crisis

Canadians are experiencing a cost-of-living crisis as everyday goods rise considerably. The cost-of-living crisis means that businesses are effectively passing on the increased costs of their supply chains to ordinary people.

It can be challenging to deal with the problem, but there is a solution. Savvy investors are hedging their bets and decreasing their exposure by trading out of the Canadian dollar and into other currencies.

Traditionally, the Japanese Yen has been the most widely recognized safe-haven currency because of its stability and static interest rates. You can preserve the value of your money too by using forex trading platforms like: https://www.avatrade.ca/forex

The effect of rising interest rates

International investments could be the cure to rising interest rates. Increasing interest rates do often encourage more foreign investment in a country. However, interest rates rising out of control can increases risk, which can actually deter people from entering the market for a particular currency.

It’s important to examine the big picture, such as why a country might be increasing its interest rates. Right now, major economies are all following the same path to counteract inflation rather than out of the weaknesses of their economies.

Interest rates give your money more value in the bank because savings rates increase. Moreover, the value of the currency appreciates because of the influx of foreign capital.

Unfortunately, interest rates have their major downsides. Anyone who holds loans, such as mortgages and auto loans, can find themselves paying more every month to service their loans. Higher interest rates also make it costlier to borrow, which can prevent investment in businesses.

Conclusion

Currency strength is influenced by a variety of factors, including trade balance, inflation, interest rates and market sentiment. Right now, soaring inflation is fueling a cost-of-living crisis, which central banks around the world are attempting to manage by raising interest rates.

Trading into and out of currencies gives you a chance to preserve the value of your money and reduce the risk of depreciating currency strength from impacting your savings.

Are you holding any foreign currencies as a defensive measure?

Photo: Pexels, Rodnae Productions