The USD had one hell of a ride which prevented inflation from rising any further. But it can’t be long now.
By Wolf Richter. This is the transcript of my podcast THE WOLF STREET REPORT recorded last Sunday.
The US dollar has had one hell of a ride since it became clear that the Federal Reserve would eventually have to start tightening as inflation started to run rampant.
That inflation was starting to rage became clear in February 2021. The Federal Reserve publicly dismissed it as temporary, at least, and offered all sorts of bogus reasons why this was just an outlier.
But I was yelling about inflation back then and explaining why it wasn’t ephemeral and why it wasn’t an outlier and a lot of people were yelling about it and explaining why it wasn’t ephemeral and certain corners of the markets knew it wasn’t ephemeral . And we who yelled about inflation back then, we all knew that at some point the Fed was going to deal with inflation, had to deal with inflation by tightening monetary policy. It would end its asset purchases, raise interest rates and begin quantitative tightening.
And the FX markets knew it too.
In February 2021 — that infamous February when many of the crappiest stocks peaked and then plummeted 80% or 90% — that February 2021, the US dollar did an about-face against major freely traded currencies, including the euro and the yen.
Back then, in February 2021, it cost $1.20 to buy €1. Since then, the dollar has appreciated sharply against the euro. On Friday morning, it took pretty much $1 to buy €1. The last time this “parity” occurred was in 2002.
The dollar is also up against the Japanese yen. On Friday, it cost over 136 yen to buy a dollar. The exchange rate has been around 136 since late June. You’ll 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 US’s 22 largest trading partners, so not just the euro and yen, but also the Chinese renminbi, Mexican peso, Hong Kong dollar, Canadian dollar, Brazilian real , the Thai baht, etc. 22 of them.
For this broad dollar index, currencies are weighted by trade volume with the US. And there is an inflation-adjusted version of this broad dollar index called the Real Broad Dollar Index. This index dates back to 2006 and reached its highest level since the index began at the end of June. Since February 2021, it has increased by 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 hit an all-time high in the first quarter of this year.
Import prices also shot up, but the strong dollar has mitigated the rise in the price of these imports. In the euro zone and in Japan, the ailing currencies have meant that import prices have risen even more than in the USA.
So the strong dollar has helped curb raging inflation in the US. This frenzied inflation, which has been over 8% based on CPI over the past few months, would have been higher if the dollar had not strengthened so much since February 2021, when this frenzied inflation began.
The US produces many commodities, including crude oil, petroleum products and natural gas, as well as food and metals, etc. But it imports a huge amount of high-value goods, including bulk consumer goods, from cellphones to automobiles. and components, electronic products, industrial products, home appliances… you name it.
For example, Boeing’s battered 787 Dreamliner is assembled in the United States, but many of the parts and components are manufactured and imported in countries around the world. Automakers that assemble vehicles in the US import many components from other countries. Added to this is the large amount of expensive finished products that are imported.
That’s how the US has this huge gigantic trade deficit – and these commodities are paid for in dollars and as the dollar strengthens it lessens the bite of the price hikes that are now cascading around the world.
The exchange rate, e.g. B. the dollar against the euro, is a result of market movements in the vast foreign exchange market. Currencies are traded against each other and there is a lot of speculation, including currency-based derivatives and hedging, from retail day traders to giant trading houses. And so exchange rates fluctuate from one second to the next.
Then there is a separate action that affects currencies and anything denominated in those currencies, and that is inflation. Inflation reduces the purchasing power of this currency in your own country. The dollar’s purchasing power in the US has been shaken by this rampant inflation. Everyone knows what that means: you have to pay more dollars for the goods and services you buy.
These two dynamics – exchange rates and the purchasing power of domestic currencies – do not necessarily move in the same direction in the short run. Exchange rates are determined by trading in the massive foreign exchange market. Inflation has other causes.
So why has the dollar appreciated against the euro and the yen when there is so much inflation in the US?
First, the eurozone now has about the same raging inflation as the US, and in some eurozone member states inflation is much worse, in the double digits, and in some it’s over 20%, which is a terrible number. And even in Japan, inflation is now picking up speed.
Second, the Fed has been on a tightening path since the beginning of this year – and now on a fairly aggressive path with rate hikes of 75 basis points and quantitative tightening. But both the European Central Bank and the Bank of Japan are sticking to negative interest rates.
The ECB will start tightening with the first rate hike this month and a larger rate hike in September, as well as QT. There are now some ECB governors talking about an aggressive rate hike in September. One of them was just saying that the ECB should rise by a percentage point and a half in September to counter this runaway, rampant inflation in the euro zone. Which would be huge.
The Bank of Japan has vowed not to tighten policy for now, but that too could change if the yen slides further lower. Japan already has a large trade deficit, partly due to the slump in the yen making imports much more expensive, and Japan imports a huge amount of energy commodities, food commodities, other materials and many components and finished goods including consumer electronics and all sorts of stuff.
So central bank tightening is generally supportive of the currency exchange rate and the Fed got there long before the ECB will get there and the Bank of Japan is still stuck in its old ways.
The Bank of Japan may eventually be forced to follow suit. All of the other major US trading partners, with the exception of China, have already raised interest rates, some of them massively, such as Brazil.
And this tightening drama in other countries will eventually affect exchange rates and the dollar could then reverse and lose ground again.
Hedge fund manager Stanley Druckenmiller said about a month ago that the Fed’s early tightening boosted the dollar but that the US economy was nothing out of the ordinary, adding: “I’ll be surprised if I see it anytime in the next few years.” haven’t shorted the dollar for six months.”
The dollar is trading at a precariously high level. And historically, when it traded at precariously high levels against other major currencies, it was thrown back down. And sometimes a lot.
And that’s likely to happen again at some point, maybe not tomorrow or in July or in August, but it’s likely to happen when the ECB starts catching up with the Fed.
It would be nothing special if the dollar returned to the mid-20 year trading range against the major currencies. It has done so before. And in the past it overshot the mark on the way down.
And when the dollar returns to mid-range or below, something else will automatically happen: it will lift the lid that the strong dollar has put on inflation.
A weaker dollar will fuel US inflation via import prices — particularly high-value manufactured goods and components — with new fuel. And just as durable goods inflation eases, this new fuel is thrown on top – a weaker dollar.
The exchange rate affects the pricing of imported goods with a time lag. Many of these prices are negotiated in dollars months in advance, so a weaker dollar would only gradually contribute to US CPI inflation, and this could happen later this year and then more intensely next year. Just when people are expecting durable goods inflation to slow down somehow, suddenly there would be extra fuel for more inflation.
This raging inflation is unlikely to drop below 5% anytime soon, now that inflation is firmly entrenched in services, where nearly two-thirds of consumer spending ends up. These CPI rates fluctuate from year to year, they always do, and sometimes quite sharply, but just when they look like they’re going back into acceptable range, they bounce back.
And we’re going to see some of that, we’re going to see CPI interest rates go down a bit, and then they’re going to go back up, and there’s going to be a lot of reasons for that, but part of the rebound is going to be because the dollar is losing versus other major ones currencies on the ground.
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