The USD made quite a turn, which kept inflation from climbing even higher. But that may not last long.
By Wolf Richter. This is the transcript of my podcast recorded last Sunday, THE WOLF STREET REPORT.
The US dollar has had a hell of a ride since it became clear that the Federal Reserve would eventually have to start tightening its reserves because inflation was starting to rage.
This inflation was starting to rage became clear in February 2021. The Federal Reserve, at least in public, called it transient, and they came up with all sorts of bogus reasons why it was just a blip.
But I was screaming about inflation back then, and explaining why it wasn’t transitory, and why it wasn’t a hit, and a lot of people were shouting about it and explaining why it wasn’t. was not transient, and some corners of the markets knew it was not transient. And we who were crying inflation at the time, we all knew that the Fed would eventually suppress inflation, should suppress inflation, and it would do so by tightening monetary policy. It would end its asset purchases, it would raise interest rates and it would start quantitative tightening.
And the forex markets knew it too.
In February 2021 – that infamous February when many of the shittiest stocks peaked and then crashed 80% or 90% – in February 2021 the US dollar turned around against the major currencies which trade freely, including the euro and the yen.
At the time, so in February 2021, it took $1.20 to buy €1. Since then, the dollar has soared against the euro. On Friday morning, it took almost exactly $1 to buy €1. The last time this “parity” happened was in 2002.
The dollar also surged against the Japanese yen. On Friday, it took more than ¥136 to buy a dollar. The exchange rate has been around 136 since the end of June. You have to go back to the late 1990s to find these exchange rates.
The Federal Reserve maintains a broad dollar index that includes the currencies of the United States’ 22 major trading partners, so not only the euro and the yen, but also the Chinese renminbi, Mexican peso, Hong Kong dollar, Canadian dollar, Brazilian real, Thai bain, etc. 22 of them.
For this broad dollar index, currencies are weighted by the volume of trade with the United States. And there is an inflation-adjusted version of this broad dollar index, the so-called “Real Broad Dollar Index”. This index dates back to 2006, and by the end of June it had reached its highest level since the start of the index. Since February 2021, it has gained almost 11%.
The sharp rise in the dollar since February last year has had a significant impact on inflation because we have had a huge goods trade deficit with the rest of the world. This trade deficit reached a record level in the first quarter of this year.
Import prices also rose, but the strength of the dollar dampened the surge in import prices. In the Eurozone and Japan, their battered currencies pushed up import prices even more than in the United States.
Thus, the strength of the dollar helped to contain galloping inflation in the United States. This raging inflation, which has been above 8% for the past few months according to the consumer price index, would have been higher if the dollar had not gained so much strength since February 2021, when this raging inflation began.
The E. and components, electronics, industrial products, home appliances… you name it.
For example, Boeing’s troubled 787 Dreamliner is assembled in the United States, but many parts and components are manufactured in countries around the world and are imported. Automakers that assemble vehicles in the United States import many components from other countries. This is in addition to the large volume of high value-added finished products that are imported.
That’s how the United States gets to have this huge gigantic trade deficit – and those goods are paid for in dollars, and when the dollar strengthens, that lessens the impact of the price increases that are now reverberating around the world .
The exchange rate, like the dollar against the euro, is the result of market action in the broad currency market. Currencies are traded against each other, and there is an enormous amount of speculation going on, including with currency derivatives and hedging, from retail day-traders to gigantic trading houses. Thus, exchange rates fluctuate from second to second.
Then there’s a separate action that impacts currencies and anything denominated in those currencies, and that’s inflation. Inflation reduces the purchasing power of that currency in its own country. The purchasing power of the dollar in the United States has been shaken by this galloping inflation. Everyone knows what that means: you have to pay more money for the goods and services you buy.
These two dynamics – exchange rates and the purchasing power of currencies in their own country – do not necessarily move in the same direction in the short term. Exchange rates are determined by trading in the massive currency market. Inflation has other causes.
So why has the dollar soared against the euro and the yen when there is so much inflation in the United States?
First, there is now about the same runaway inflation in the Eurozone as in the United States, and in some Eurozone member states inflation is much worse, in double digits, and in a few cases, that’s over 20%, which is a horrible number. And even in Japan, inflation is taking off.
And second, the Fed has been on a tightening path since the start of this year – and now on a fairly aggressive path, with 75 basis point rate hikes and quantitative tightening. But the European Central Bank and the Bank of Japan still maintain negative interest rates.
The ECB will kick off the tightening with the first rate hike this month and a bigger rate hike in September, and with QT. Some ECB governors are now talking about an aggressive rate hike in September. One of them just said that the ECB should increase by a point and a quarter in September to deal with this galloping inflation in the euro zone. Which would be huge.
The Bank of Japan has so far pledged not to tighten policy, but that too could change if the yen continues to fall. Japan already has a large trade deficit, partly due to the fall of the yen, which makes imports much more expensive, and Japan imports a huge amount of energy products, food products, other materials and many components. , and finished goods, including consumer electronics, and all sorts of things.
So central bank tightening usually supports the currency’s exchange rate, and the Fed got there long before the ECB got there, and the Bank of Japan is still stuck in its old ways.
The Bank of Japan may eventually be forced to follow. Every other major U.S. trading partner except China has already embarked on rate hikes, and massive rate hikes in some cases, such as Brazil.
And this tightening drama in other countries will eventually impact exchange rates, and the dollar could then reverse and lose ground again.
Hedge fund manager Stanley Druckenmiller said about a month ago that early Fed tightening had boosted the dollar, but there was nothing out of the ordinary in the US economy, and he added: “I would be surprised if, over the next six months, I wouldn’t be short the dollar.
The dollar is trading at extremely high levels. And historically, when it traded at precariously high levels against other major currencies, it was knocked down. And sometimes a lot.
And it might happen again at some point, maybe not tomorrow, or in July or August, but it might happen as the ECB starts trying to catch up with the Fed.
There would be nothing special for the dollar to return to the middle of the 20-year trading range against major currencies. He has already done it. And in the past, it exceeded on the way down.
And if the dollar’s exchange rate returns to the middle of the range, or lower, then something else will automatically happen: it will remove the lid that the strong dollar had put on inflation.
A weaker dollar will fuel inflation in the United States via import prices, especially finished goods and high-value components. And just when durable goods inflation might come down, then there will be this new added fuel – a weaker dollar.
The exchange rate has a delayed impact on the prices of imported goods. Many of these prices are traded in dollars months in advance, so a weaker dollar would only gradually fuel consumer price inflation in the United States, and that could happen later this year. , then more intensely next year. Just when people expect durable goods inflation to somehow run out of steam, there would suddenly be additional fuel for more inflation.
This runaway inflation is unlikely to drop quickly below 5%, now that inflation has firmly entrenched itself in services, where nearly two-thirds of consumer spending ends up. These year-over-year CPI rates fluctuate, they always fluctuate, and sometimes by a lot, but just when they seem to be getting back into the acceptable range, they start to rise again.
And we’re going to see some of that, we’re going to see CPI rates go down a bit and then they’ll come back up, and there’s going to be a lot of reasons for that, but part of the resurgence will be due to the dollar as it loses ground against other major currencies.
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