Why inflation matters for the exchange rate
Inflation affects GBP/USD through two channels that can pull in opposite directions. In the short term, a hot inflation print raises the odds that the central bank will keep rates higher for longer, which tends to strengthen the currency. In the long term, sustained high inflation erodes a currency’s purchasing power, which tends to weaken it. For day-to-day Cable moves, the short-term, rate-expectations channel usually dominates.
CPI, PCE and core measures
The UK and US measure inflation slightly differently. The Bank of England targets the Consumer Prices Index (CPI). The Federal Reserve’s preferred gauge is the Personal Consumption Expenditures (PCE) price index, though US CPI is released earlier and tends to be the bigger market mover on the day. Both economies also watch core inflation, which strips out volatile food and energy prices to reveal the underlying trend.
It’s the gap that moves Cable
As with interest rates, GBP/USD responds to the difference in inflation trajectories between the two economies, because that difference shapes the expected interest-rate differential. If UK inflation proves stickier than US inflation, markets price more Bank of England tightening relative to the Fed, which tends to support the pound — and vice-versa. A single surprise in a UK CPI release or a US jobs/CPI report can move Cable sharply within minutes.
Real yields: the deeper signal
The most durable driver is the real (inflation-adjusted) interest rate. A currency with high nominal rates but even higher inflation offers a poor real return; one with rates comfortably above inflation offers a good one. Over months and years, GBP/USD tends to drift toward whichever currency offers the better real yield, which is why inflation and rates have to be read together rather than separately.