For a commodity, oil has a tremendous impact on the currency market. Despite many investors disregarding its influence, oil is the cause of some of the most aggressive moves in the forex market.

The price of oil fluctuates on the free market like the price of any other commodity. Forex investors can buy or sell oil using CFD’s (Contracts for Difference) as with any other currency pair on the forex dashboard. But this article isn’t about the technical aspect of trading oil. Instead, it deals with oil’s impact on the volatility of the forex market.

Oil and inflation

Inflation is the number one priority of every central bank’s mandate. More precisely, economic studies reveal that economic growth requires some inflation. According to central banks, around two percent inflation is ideal for a healthy, growing economy. Therefore, monetary policy decisions are focused on driving inflation towards that target.

The price of oil has a strong inflationary component, driving inflation higher or lower in a direct relationship; higher oil prices result in rising inflation, lower oil prices result in declining inflation. Therefore, central banks constantly monitor the price of oil, so they can adapt their monetary policy to the prevailing conditions. They even prefer to “filter out” the effects of the price of oil when measuring inflation. Therefore, when it comes to the monthly Consumer Price Index (CPI) inflation data, central banks focus on the core number, which excludes energy prices.

Sudden drops in the price of oil have substantial implications in the FX world. Because of this, central banks postpone interest rate decisions, change forward guidance, and even take emergency measures to adapt as quickly as possible to oil-related news. All these actions create great volatility in the forex market and are of the utmost importance to investors.

What moves the oil market?

We can say without a doubt that central banks closely monitor the changes in oil prices. But what makes the price of oil move?

Supply and demand play a crucial role. Disruptions in supply and demand due to conflicts, war zones, politics, OPEC (Organization of Petroleum Exporting Countries) meetings, can all affect the price of oil. Forex investors closely monitor changes and adjust inflation expectations based on information from the oil market.

One critical release for the price of oil is the U.S. Crude Oil Inventories. As the world’s largest economy, the United States’ oil consumption acts as a bellwether for the world’s economic growth. Higher inventory levels suggest too much supply coming to the market or sluggish growth. In both cases, the price of oil would typically fall and pull inflation lower as a result.

Take-aways:

• The price of oil and inflation has a direct relationship.
• OPEC and general fluctuations in supply and demand levels affect the price of oil.
• Oil is the cause of tremendous volatility in the FX market.
• The U.S. Crude Oil Inventories is a great indicator of the health of the largest economy in the world.