Inflation and Exchange Rates

To understand the impact of inflation, several terms should be understood. For example, inflation from the investors' standpoint must be clearly delineated with respect to expected inflation and changes in expected inflation. Two opposing relationships should be defined between securities markets and expected inflation and between securities market changes and expected inflation. Nominal output is expected to be higher with higher inflation than with lower inflation. If inflation rate in future is expected to be high and stable, a higher security return will be required. Thus, we find a positive relationship between stock returns and inflation. This positive relationship is further supported by the fact that investors will seek compensation for the erosion in their real value of return by demanding higher security returns. However, this positive relationship is challenged by a negative relationship between security return and inflation during the times of rising inflation. Because of these two opposing relationships between inflation and security returns, a careful observation is required to identify whether the relationships have been established using the actual inflation level or due to changes in the inflation expectation.

Studies done by Fama, Geske and Roll have confirmed that inflation and the real economy do interact with each other. Further, proven studies have also revealed that inflation and the real output are negatively related. Beyond the real output effect, which reduces the aggregate pool of returns, changes in inflation expectations have a wealth transfer character. Any increase in the rate of interest has a direct effect on reducing the future payment in money. The increase in inflation expectations directly reduce the value of future obligations that are quoted in monetary terms. A rise in inflation debases money relative to real goods and services and therefore, debases all future monetary obligations with respect to future opportunities to buy goods and services.

Generally, bonds are subject to wealth transfer by increasing inflation expectation. For, a bond, which is a fixed promise to receive a nominal dollar or rupee amount in future, will be directly and fully debased by a rise in inflation expectations. On the other hand, a real estate security that involves an assortment of promises to receive future payments and to pay future expenses could be affected differently. A human laborer, on the other hand, who continuously negotiates his employment contract, can have a positive, or even neutral impact depending upon certain other factors.

The changes in inflation expectation also affect the expectations of future price change volatility. The increased expectations of inflation volatility makes it very difficult for rational risk-averse economic agents to make long-term capital decisions, which also provides the platform for growth in productivity. At the threshold limit, greater uncertainties over future change in prices encourage present consumption at the extent of capital expenditure. It is to be mentioned here that today in certain overseas markets where volatility inflation rules it is difficult to float a bond with much more than a 10-year maturity.