Inflation and the currency markets – what’s the deal?
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I’m sure that, behind the typical Covid-19 related news coverage, you have seen reports that indicate inflation is at multi-year highs and that the central banks are suggesting a more hawkish policy is on the way, but what does this all mean?
In a nutshell: Larger money supply => higher inflation => higher interest rates => stronger currency.
If you are only interested in the impacts of higher inflation on the currency markets, you can stop reading now; the rest of this article breaks down the topic into slightly more detail.
What is inflation?
Inflation is the rate at which prices increase in a period, usually annually. Classical macroeconomics suggests that inflation is related to the money supply, the total amount of money in circulation or in existence in a country. This theory is known as the equation of exchange. It articulates that, assuming a constant(ish) rate at which people spend cash, there is larger inflation as the money supply increases. That makes sense – more money supply implies more cash in the consumer’s pocket and more lavish spending.
Relating this economic theory to reality, as the pandemic roared, the central banks looked to bridge the lack of consumer spending by adding money to the system through fiscal (Economic rescue packages) and Monetary (Interest rates and quantitative easing) action. However, now that we are in the endemic stage of the Coronavirus outbreak, and customers have begun to readopt their previous spending habits, the rate at which they are spending money (velocity) is returning to pre-pandemic levels. The implications of this are an increase in price levels across the board – higher inflation!
When looking at inflation, there are often two broad terms used by central bankers, namely, transitory and persistent inflation. Transitory inflation is pandemic-produced price hikes, most likely induced by global supply chain issues and is not of too much concern to the long-term welfare of the broader economic system. However, persistent inflation would suggest that price hikes are most likely permanent; persistently high inflation is one of the prominent issues plaguing the global economy right now.
What are the central banks doing to counter this?
To counter the recent surge in inflation, central banks across the world have hinted at taking a more hawkish approach to monetary policy. A Hawkish monetary policy often points to interest rate hikes and the scaling back of Quantitative easing (bond buybacks), both of which remove money from the financial system.
A simple analogy is to imagine that the central banks are the drivers, the economy is a car, the gas pedal is monetary policy, and the car’s speed is the inflation rate.
So to speak, most central banks have taken their foot off the gas but haven’t yet touched the break; however, this is expected to change in 2022.
Higher inflation = stronger currency?
As central banks begin to hike interest rates, you may be wondering how this will affect the global currency markets. Thinking logically, as the Fed increases interest rates, the returns on bonds (bond yields) will also increase. This encourages foreign investors to purchase bonds from overseas, which will drive up the demand for the currency and thus the price!
To conclude: higher inflation => higher interest rates => more foreign investment => stronger demand for domestic currency => higher price level.
