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On April 24 we heard the news that Australia's inflation came in well below expectations, climbing just 0.1% in the March quarter and taking year-on-year inflation to 1.6%, below expectations of a 2.2% rate. The Australian Dollar (NYSEARCA:FXA) took a slight beating, since the market saw the news as making it easier for the RBA to cut Australia's interest rates.

But is lower-than-expected inflation really bad for a currency? It happens that, theoretically, quite the contrary is true. If we subscribe to the purchasing power parity theory, which says that over time a large basket of tradable goods will be worth about the same when valued under any free-market trading currency, then the currencies exhibiting lower inflation should gain in value. And conversely, those having higher inflation should lose value. This is easy to understand: Let's imagine that only one good exists and it costs 1 in currency A, and 1 in currency B. After some time, B had inflation of 100% and A had no inflation. Now the good costs 1 in currency A, and 2 in currency B. For purchasing power parity to be maintained, B's currency now has to be worth half its previous value. Hence, higher inflation means lower currency value over time.

It's perhaps not surprising, then, that the Japanese Yen (NYSEARCA:FXY) remained strong over so many years even while showing very weak economic growth and incredibly low interest rates -- that's because Japan also had very low inflation that entire time.

But getting back to the Australian dollar. Since the market's reaction was less than rational as we saw above, I took the chance to cover an AUD/USD short. Not that inflation exerts its effects on the very short term, of course. But it's always interesting to see how the market reaction in the short term can go against the very nature of the news pushing the exchange rate around. So next time you see a headline "Country X Inflation Unexpectedly Slows; Currency Weakens," you now know just how crazy it can get.

This said, I still expect the Australian dollar to lose value over time due to the weakening economy, the expected deterioration in external trade (though not right away due to seasonality), and, over time, the need for money printing that should emerge. Simply put, I don't expect low inflation to be a culprit here.

Source: Inflation And Foreign Exchange