Why exchange rates move: interest rates, inflation and the policy path
Do not look at one country's data in isolation; ask whether it is strengthening or weakening relative to the other.
An exchange rate is a relative price
When EUR/USD rises, it may be the euro strengthening or the dollar weakening. Determining which requires comparing the policy and growth of both economies. That is why forex analysis has to be done in pairs: US data alone cannot tell you the direction of EUR/USD without the corresponding euro area data.
Interest rate parity: the differential sets the forward premium
The most fundamental relationship in international finance is interest rate parity. Covered interest parity states that the difference between the forward and spot rates of two currencies should equal the difference between their interest rates; otherwise a riskless arbitrage would exist. In practice CIP deviates because of capital controls, transaction costs and balance sheet constraints, but it remains the benchmark for understanding forward quotes.
Uncovered interest parity states that a higher-yielding currency should in theory be expected to depreciate by roughly the size of the differential. That explains why "buy the high yielder" is not riskless arbitrage: in a carry trade the return comes from the differential while the risk comes from exchange rate movement, and that movement is often far larger than the differential.
Policy rates are the most direct driver
The policy rate set by a central bank is the source of every differential in the market. The main central banks to track are the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England. In mid-October 2026 the rate environment was roughly as follows: the ECB raised its deposit rate to 2.50% in September; the Bank of Japan raised its policy rate to 1.25% on 18 September; the Bank of England held its benchmark at 3.75%.
How data reach the policy path
Data do not set the exchange rate directly; they move it by changing the market's expectations of the policy path. The chain runs: data → inflation and growth expectations → expected policy path → rate differentials → exchange rate.
Take the two sets of US data from September 2026. On inflation, CPI rose from 3.4% to 3.7% year on year against a 3.6% consensus; the monthly rate was 0.6%, the largest in five months; core CPI rose 0.3% on the month. On employment, payrolls added only 29,000 against a 90,000 forecast, the unemployment rate rose to 4.2%, and July and August were revised down by a combined 60,000.
The two releases point in opposite directions, yet the market's actual reaction leaned towards inflation: the cumulative probability of one more Fed hike before year-end was pushed above 85%, implying a hold in October and a 25 basis point increase in December. The dollar index closed at 102.53 on 14 October, an 18-month high. Meanwhile the New York Fed's Survey of Consumer Expectations showed one-year inflation expectations rising from 3.58% to 3.9%.
The conclusion from that case: while inflation remains above target, the marginal influence of inflation data on the policy path is typically greater than that of employment data. Judging the weights matters more than memorising the numbers.
Three categories of data to track
- Inflation: CPI, PPI, core inflation, inflation expectation surveys
- Employment: non-farm payrolls, unemployment rate, participation rate, jobless claims
- Policy: rate decisions, meeting minutes, official commentary
Exact release dates and times are published by national statistical agencies, and can be used to schedule position sizing and pause rules in advance.
Lesson summary and self-check
- An exchange rate is a relative price, so both economies must be analysed as a pair.
- The rate differential is the benchmark for the forward premium (interest rate parity); carry trades earn the differential and carry exchange rate risk.
- Data move the exchange rate by changing expected policy paths, not directly.
- While inflation remains above target, inflation data usually carries more marginal weight than employment data.
Self-check: (1) If US inflation beats expectations while employment weakens, is the dollar more likely to strengthen or weaken, and why? (2) Why is a high-yielding currency not automatically worth buying?