• 23 May 2022

US slowly slipping into stagflation?

The US Inflation hit a new 40-year record high in March as the consumer prices rose 8.5%, which is the highest since 1981. But declined slightly in April, with the 12-month figure falling slightly to 8.3%. April core CPI for the last 12 months rose 6.2%, versus the 6.5% gain in March.

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The negative shock waves triggered by supply chain disruptions on account of COVID-19 was just the beginning. The cumulative effects of sanctions against Russia over the war against Ukraine added more tension. The war has led to a seizing up of world energy and commodity markets. The spike in oil prices in March will not only keep inflation soaring high but could possibly catalyze a recession, as energy prices drive up costs for consumers and companies. In the past two years, the money supply has increased from $15.5 trillion to $21.8 trillion. Looking at the consumer level, while wages are still gaining, they’re growing at a lower rate than prices overall. Further, there are signs of increased expenditure and less savings as consumers seem to have shifted their spending from goods to services (like restaurants and vacations) when Covid-19 restrictions were relaxed.

This is when The Federal Reserve comes into picture. They aim to keep inflation under control and maximize employment. Earlier this month, the Federal Open Markets Committee (FOMC) delivered their first 50 basis point (bps) rate hike in the past 20 years. The move marks the Fed’s big monetary policy push to crush inflation by controlling money supply in the market. The Fed was insisting that inflation was just transitory, we need to wait until prices stabilise. But the market is skeptical about this. The market fears that the Fed has misjudged the inflation and the ‘softlanding’ plan might not work out effectively as expected.

It is speculated that the Fed will hike rates by 0.75 basis points in June and July also. If the Fed plans to aggressively hike interest rates in such a short span, many economists fear that a situation of hyperinflation combined with sluggish economic growth called ‘Stagflation’ is likely to take hold.

Considering all this, we would expect the USD to be deep diving but it is rather skyrocketing on a relative basis. DXY, which is USD against a basket of foreign currencies, has gone to multi-year highs. In fact the last time DXY was higher than this was back in 2002 or nearly 20 years. So clearly, while the USD is getting crushed in terms of buying power, it is actually gaining dominance over world currencies. So how does this make sense?

Currency is a stable medium of exchange with very little scope for volatility during normal situations. However currencies are also subject to fundamental demand and supply characteristics. They can experience extreme volatility especially with unusual events like printing trillions of dollars as part of monetary policy changes followed up by suddenly raising interest rates.

In the event of a crisis like outbreak of COVID19, many Central Banks have pumped trillions of money to jolt life into their economies. The rate of money printing by other Central Banks is higher than the U.S on a relative basis, similarly many countries are not pulling back as aggressively as the US currently is. This disturbs the exchange rate between foreign currency with USD. This has led to the USD performing better than other currencies. Further, high uncertainties like whether the Fed will hike rates by 0.75 basis points in June and July will also affect currencies just like preemptive stock market corrections. Uncertainties give USD significant buying pressure. Historically, during high inflation periods, investors tend to move a significant portion of their wealth into inflation hedges like Gold. But if we check the weekly charts, we can see that gold has not moved much since July, it is almost around the 2011 range. This could mean that the money that is cashing out from the stock market could just be held as liquid cash, which in turn makes USD demand go high.

However, how long DXY’s hike would continue, is a question of caution.

Why is USD Soaring?

“The WSJ Dollar Index, which measures the U.S. currency against a basket of 16 others, has risen 7.1% in 2022, outpacing everything from stocks to bonds to gold.” (McCabe & Verlaine, 2022). It is being noticed that the American economy is experiencing ‘red hot inflation’, in other terms hyperinflation. Usually in such scenarios, if we observe the currency in isolation, i.e, without taking into account the other factors aiding its strength, the US Dollar (USD) would be considered to be weak.

However, one look at the market and it can be noticed that USD is soaring high when compared with other currencies such as the Pound (GBP), Euro (EUR) and Yen (JPY). There are a number of reasons for this such as :

1. The rise in the Federal Reserve’s policy rate from the current 0.25%-0.5% range to 0.75%-1% at its rate-setting meeting, which is a predictable action for curbing the increasing inflation in the country.

2. EUR is one of the most frequently traded currencies against USD, which is presently facing gas supply pressure due to the Russian-Ukraine war. Since Russia has been one of the biggest suppliers of gas to most of the Euro zone countries, a ban on this commodity especially on countries like Italy and Germany could lead to the trigger of one of the largest Economic recessions in the entire zone.

3 .GBP has been trying to stabilize its strength after the long-drawn BREXIT. But, after the government’s recent announcement relating to the hike in the cost of living and the potential risk of the occurrence of widespread economic recession, the currency’s value, especially with USD has spiraled down to major lows, as can be seen in the chart.

In conclusion, USD’s strength cannot be observed in isolation since it has multiple factors tagged to it, the fact that it is the most widely used currency across the globe when it comes to trade or any other major financial transaction between countries, aids its strength.

However, this strength is not good news for the emerging economies, especially for the ‘Fragile Fives’(2021),i.e., Brazil, Indonesia, Turkey, India, South Africa. As much of their debt is denominated in USD, with the increase in strength of the major currency, the debt servicing requirements would draw out more capital from the economies towards the US.

Therefore, due to the presence of a legacy-like journey of the currency, USD is soaring new levels despite the rising economic challenges in the country, while other currencies are trying hard to keep up with the pace.

Also Read:- Crypto Currency and Its Effect on Dollar

- Arushi Saxena & Alina Helen