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Understanding the relationship between inflation and interest rates for a particular currency can help you decide whether or not that currency is growing stronger or weaker, and whether you should be buying or selling that currency. Inflation tends to be a constant factor in today’s monetary system, and typically inflation is an indication of economic strength and an expanding economy.

As employment levels and wages rise, people have more money to spend and prices will tend to rise as a result of the increase in the money supply. This is the basic cause of inflation, and while inflation levels that are kept in check can lead to sustainable economic growth, unchecked inflation levels can spell economic disaster as the economy can literally collapse under its own weight leaving hard-working citizens with money that has had its value and buying power eroded. Understandably, the Federal Reserve and all other central banks will monitor inflation levels very closely, and one of the best ways to combat inflation levels is by raising interest rates.

When interest rates are low, you may not be earning as much money on your savings but it is much easier to borrow money for a house, car, business, or any other type of credit. It is this ease of access to new money that can contribute to the cycle of inflation. However there can come a time when inflation levels are rising too far too fast, and instead of creating economic growth in a sustainable fashion it can lead to an out of control economy in overdrive that can lead to something that Alan Greenspan called “confiscation by inflation,” meaning that the value of each person’s money is eroded by the large increases in the overall money supply.

Raising interest rates will keep inflation in check by tightening the credit markets and making more difficult to gain access to new money, thereby shrinking the growth of the monetary supply and making harder to gain access to loans. The relationship between interest rates and inflation levels is an important one to understand if you are a forex trader, because keeping tabs on these simple metrics can help you determine where the overall trend of the currency is and whether you should be buying or selling. A lower interest rate will mean that your money does not grow as quickly as a factor of time, but it can also mean that the country is experiencing economic growth as loans and credit are more easily available, which means the value of a currency can increase in the foreign exchange markets despite the higher inflation levels.

However, inflation does not always indicate economic growth. There have been historical instances of inflation coupled with increasing unemployment and decreasing wages, and this type of economic condition is called stagflation. Stagflation can be crippling to a country’s economy and is a central bank’s worst nightmare in terms of figuring out how to solve this problem. Back in the 1970s when the United States first abandoned the Gold Standard under President Nixon, there was rampant stagflation that had to be countermanded with extremely high interest rates that went as high as 20%. This is an example of what can happen when inflation levels are left to run wild, and it can leave you with more money but far less buying power.

The Forex market is influenced by many different factors. Because of the world wide economy, knowing the economic reports in Switzerland may be as important to one trader as what the Yen is doing against the US Dollar. Countries release economic reports to show the health of their local economies, and one of the major reports that all Forex traders look forward to is the Consumer Price Index (CPI).

The CPI acts like a mutual fund of indicators. It takes into account the average price level that is paid by the common consumer for basic goods and services, and covers over 200 different categories from food to medicine to gas to house prices.

After assessing all changes in prices for these areas, a report is issued that helps reveal how much inflation is taking place in an economy, and how much pressure that economy is under by these forces.

Inflation is not good for an economy, as rising inflation often makes it harder for consumers in a nation to buy even basic goods, meaning there is less free money for retail sales and spurring economic growth.

The CPI report shows how heavily inflation is affecting a nation, and inflation doesn’t just strike an economy that is struggling – in fact inflation can crop up in a booming economy that is growing too fast without any checks or balances! This is why inflation needs to be measured aside from other economic indicators.

For example, in an economy that started booming, similar to the way China has grown in recent years, more people make more money. They start buying more. Stores not directly affected notice this, and raise their prices. So the workers demand more money, the company pays more money, and the stores keep raising prices. Without any checks or balances, this economic boom can send the inflation through the roof. A CPI report can show this, and encourage the government and federal banks to counter.

The CPI can sometimes be affected by a large hike in price of one commodity. For example, the huge jump in oil prices in the United States. This affects transportation, heating, food, and cuts into retail sales because of the squeeze on workers’ budgets. In that case, one major commodity jumping in price created a domino effect that the CPI would alert traders and investors to.

As a Forex trader, the CPI will give you critical information about a nation and its economy that can translate to directly affecting a nation’s currency in the Forex market.

For a number of years US economy has enjoyed a relatively low inflation rate. According to official statements, annualized inflation over last decade or so has been in very low single digits. Depending on the source and method of calculation, the rate has been about 2%. That is despite massive infusion of funds into the economy in the form of very low interest rates.

That course of action has been long supported by US financial authorities, the FED. For years the central bank has been concerned with growth, doing everything it could to fight economic slow down and stagnation. It was done in the form of cutting interest rates and seemingly endless liquidity increase. Let’s not forget about lending hand in order to bail out large financial institutions from the masses their questionable practises created. In fact, month after month we have been treated to speeches that inflation is under control and not a threat. Until now.

Published inflation figures pertain to the so called “core inflation”, compilation of prices on consumer goods, which excludes food and energy. Runaway cost increases in oil/gas and main food commodities are finally being reflected in the number, as their effects trickle down to other areas of consumer goods. Some of the newly released figures are stunning-soaring energy costs pushed inflation up in May at the fastest pace in six months, according to data released Friday by the U.S. Labor Department. Food prices had the biggest one-month leap in 18 years in April. That’s something.

Higher energy and commodity prices also fuel inflation pressures in other parts of the world. They are being acutely felt in Asia in particular, as the region continues to function as a commodity importer/manufactured goods exporter. One way countries can offset such inflationary pressures is to allow their currencies to appreciate more rapidly. All of a sudden, within a couple of weeks, the once neglected subject of inflation has catapulted itself onto front pages.

As of this writing in mid June, finance ministers of the of the Group of Eight industrialized countries (G-8) are holding a meeting in Osaka, Japan. Main subject have been inflation causing soaring oil and food prices, which are emerging as serious threats to global economic growth. The ministers are vowing to work together to address the problem. They urged oil-producing nations to increase production to help stabilize the spike in oil prices, and called for aid to address a looming food crisis in developing nations.

In response, Saudi Arabia pledged to increase its daily output by additional 500,000 barrels a day. This is surely to stretch their capacity to an absolute maximum, but in opinions of many this decision should calm energy markets, which, by the way, do not have a shortage of supplies. The recent run up of crude oil price to new high of about $140, is likely to be the extent of the rally for some time.

Where does it leave the dollar? There is no one certain answer, but her is one very possible scenario. Inflationary pressures are likely to cause FED to halt its rate cutting policy, maybe even to start gradual rate increases. That is always appealing to Forex traders. Falling oil prices should also benefit the dollar, as record energy costs have been vilified as the single biggest force behind USD weakness (rightly or not). And one more thing, Treasury Secretary Paulson warned earlier this week that he isn’t ruling out intervening in currency markets to stabilize the currency.

So, what is the relationship between US Dollar and inflation? Under current market conditions and in light of most recent fundamental and technical developments, USD might just get a much needed bust from the much dreaded inflation. This relationship is, however, fluid and unstable. Unchecked, inflationary forces can do just the opposite some time down the road- start another Dollar slide.