How will the U.S inflation expectation affect USD?

U.S inflation expectations do not fall back even as annual CPI inflation moderates, then real rates are still likely to augur for  a weaker USD.

If the level of interest rates has any bearing at all on currency values – as seems very likely – then it is real (inflation adjusted) rates that are key, not nominal rates. In the distant past, it has been the movement in nominal rates that have tended to drive the volatility in real rates. But in the post global financial period, policy rates have converged and so too have money market rates and yields. And now, in what we hope will be the post-pandemic period, we’ve started to see huge volatility in inflation. This suggests that the inflation part of the real rate equation is the main driver of currencies now, not nominal rates. If that’s the case, it will weigh on the dollar over time.

As above mentioned, the volatility of inflation and its divergence between countries has been huge of late. If we take the U.S and Japan, for  instance, US CPI is more than 5% above Japan at the moment. This gap was less than 2% before the pandemic and has averaged just below 2% if we trace the data back to the early 1990s. But annual inflation in the U.S will presumably ease back down because a good part of the rise so far this year has been caused by the low base effects that we saw at the start of the pandemic last spring when inflation collapsed. This might suggest that real rates will start to provide significant support to USD. However, it is not actual inflation that’s the key, but inflation expectations, and these seem likely to prove more stubborn. We see that real UK rates have risen relative to the US recently, and GBP has strengthened. If, as we expect, U.S inflation expectations do not fall back even as annual CPI inflation moderates, then real rates are still likely to augur for  a weaker USD.

“We think market-based US inflation expectations will be sticky for  number of reasons. Firstly, policy support in the U.S has been so much more substantial than elsewhere. Direct fiscal support since the COVID-19 pandemic has amounted to around a quarter of U.S GDP. That’s a good five to ten percentage points of GDP more than we’ve seen in other developed nations. Monetary policy has been super easy as well with the rise in the Fed’s balance sheet much bigger, again as a proportion of GDP, compared to other major  nations. A second factor  is that the Fed has a new monetary policy strategy that seeks an average inflation level of 2%, not a point target of 2%. In our view, and that of most others, this implies that the Fed will allow inflation to rise above 2% for  longer and/or  by more than it would have done under the old policy regime. In short, there’s good reason to feel that US inflation expectations should have permanently moved up compared to those of other nations. Of course, this presupposes that the Fed and central banks can exert some sort of control over inflation which is a contentious point, particularly when it comes to central banks like the BoJ that have tried to lift inflation when policy rates have been stuck at the lower bound”, Mr. Steve Barrow, Head of Standard Bank G10 Strategy stressed.

Nonetheless, most would probably suggest – even the BoJ – that central banks can exert some sort of control and, if that’s the case, we should find that US inflation expectations have permanently ratcheted up as a result of this policy switch. Perhaps, Fed has a far more dominant role in setting global liquidity conditions than other central banks. Hence, it has to be mindful of how policy changes will play out globally. This is something that could be another factor  pushing the Fed towards having an easier policy setting and hence higher inflation, than a central bank that is unburdened in this way.

In sum, U.S inflation expectations will stay relatively high even as the annual CPI and PCE measures slip back. Unless this is counterbalanced with fast rate hikes from the Fed the consequence is likely to be a weaker USD.