Intro: Does currency weakness cause inflation or does inflation cause currency weakness? While it may appear that currency weakness causes inflation, the opposite is true. Declining export competitiveness and falling real interest rates resulting from higher inflation necessitate currency weakness. Contrary to economic theory, higher inflation prints can sometimes lead to short-term currency appreciation in developed markets, but over the longer term inflation and currency weakness go hand in hand.
Currency weakness is the consequence of rising inflation and not the actual cause, although the fact that CPI data is released with a lag can make it seem as though currency weakness is actually causing the increase in inflation. Over the long term, high inflation requires currency weakness in order to prevent a reduction in external competitiveness. In the absence of currency weakness a country with a persistently high inflation rate would face major trade imbalances due to rising export costs, which would become unsustainable.
On a shorter-term basis, another reason that higher inflation is negative for a country’s currency is that it puts downward pressure on real interest rates. This discourages financial market participants from putting their money in the country owing to lower returns, causing depreciatory pressure on the currency. The chart below shows the close inverse correlation between inflation expectations and currency performance in the US. As inflation expectations rise, this puts downward pressure on real interest rates causing the currency to weaken.
In the very short term, mainly in developed markets, a high inflation print can cause a currency to appreciate as expectations rise that the central bank will increase interest rates. However, as it is real interest rates that drive currency performance, the interest rate would have to rise in excess of the rise in inflation to suggest that the currency appreciation is sustainable.
A key point to note is that if a currency weakens absent any deterioration in the fundamental inflation pressures, this would not lead to an increase in inflation, at least beyond the very short term. Instead, in the absence of any increase in the money supply the increases in the cost of imported goods due to the weaker currency would be offset by lower prices of domestically produced goods.