How exchange rates and inflation feed each other

The relationship between a currency and domestic prices runs in both directions, which is why it is easy to state and hard to reason about. A weaker currency pushes prices up; persistently higher prices push the currency down. Neither is instant, and the lags are where most of the confusion lives.

From the currency to prices: pass-through

If a currency falls 10% against the dollar, everything the country buys in dollars becomes 10% more expensive in domestic terms. Energy, most commodities, a great deal of shipping, and a long list of manufactured goods are all invoiced in dollars regardless of who is buying from whom.

That much is arithmetic. What happens next is not, and economists call the messy part exchange rate pass-through: how much of the currency move actually reaches the shelf.

The answer is consistently less than all of it, and later than you would expect. Several things absorb the shock:

• Margins. An importer facing a competitive market swallows part of the increase rather than lose customers.
• Contracts and hedging. Large importers fix prices months ahead, so a move today shows up next year.
• The domestic share of the final price. A jar of imported olives on a British shelf carries the cost of transport, warehousing, shelf space, staff and VAT, all of which are in sterling. The imported component might be a third of the price, so a 10% currency move is a 3% cost shock, not a 10% one.
• Whether the move looks permanent. Firms reprice for what they think is a lasting shift, not for a fortnight of noise.

The general pattern from the research is that pass-through is partial, spread over several quarters, and larger in small open economies than in large ones. The eurozone and the United States, both big and relatively closed in trade terms, see less of it than a small economy that imports most of what it consumes.

Which prices move first

Not all at once, and the ordering is fairly predictable:

Category	Speed	Why
Fuel	Days to weeks	Priced in dollars, repriced constantly
Imported food, electronics	Weeks to months	Existing stock sells through first
Cars, appliances	Months	Model-year pricing, long order books
Services, rent	Slowest, indirect	Domestic costs, but wages eventually follow

The last row is the one central banks watch hardest. A currency shock that stops at fuel is a temporary bump. One that reaches wages has entered the part of inflation that does not reverse when the currency recovers.

From prices back to the currency

The return path has two mechanisms operating on different clocks.

The slow one is the arithmetic of purchasing power. If one country's prices rise 5% a year while its trading partner's rise 2%, its goods become progressively uncompetitive, and the exchange rate has to give. Over decades this dominates and explains most of the very long-run currency charts. Over any given year it is invisible.

The fast one runs through the central bank. High inflation prompts higher interest rates; higher rates attract capital and, all else equal, strengthen the currency. This can point in the opposite direction to the slow mechanism for years at a time, which is precisely why a country with uncomfortable inflation sometimes has a firm currency. The tool and its limits are covered in what a central bank can do.

What decides which force wins is credibility. If markets believe the central bank will bring inflation back down, the rate rise supports the currency. If they do not, higher nominal rates are read as confirmation that inflation is out of control, and the currency falls anyway.

Real rates, not nominal ones

The single idea that makes the whole picture consistent: what investors compare across countries is the interest rate minus expected inflation.

A 6% rate with 8% inflation loses purchasing power. A 2% rate with 1% inflation gains it. This is why raising rates does not automatically strengthen a currency — if inflation expectations rise faster than the policy rate, the real return has fallen, and money leaves.

It is also why the relationship set out in why currencies strengthen and weaken has to be stated in real terms to hold up.

What follows for anyone changing money

Mostly, patience about interpretation. A currency move you read about today shows up in shop prices over the following year, not this week, and by a fraction of its headline size.

And a caution about "cheap": comparing a rate to where it stood five years ago says little, because prices in both countries moved in the meantime. A currency 20% weaker in nominal terms after a period of 20% higher inflation is, in the terms that matter for what money buys, roughly where it was.