Era of higher inflation would lead to major currency volatility, economist says

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A currency trader monitors exchange rates in a trading room at KEB Hana Bank in Seoul on June 21, 2021.

JUNG YEON-JE | AFP via Getty Images

Markets have been gripped in recent weeks by the debate over whether higher inflation is here to stay, and analysts have suggested the result could have a big impact on currency markets.

The 10-year US Treasury yield hit a recent high of 1.56% last week as key inflation data showed consumer prices hit multi-year highs in the US and the zone euro.

While the consensus among central bank policymakers remains that the rise in inflation is transient, a result of the confluence of soaring energy prices and global supply issues, investors have started to seek protection. , with major stock markets posting winning streaks of several months in September.

The return to a higher and less stable inflation regime in the major economies would cause an increase in exchange rate volatility and, ultimately, currency depreciation in countries with the highest inflation rates. high, according to Jonas Goltermann, senior market economist at Capital Economics.

“Although the short-term relationship between inflation differentials and exchange rates is weak, in the longer term, countries with relatively high inflation tend to experience depreciation of their nominal exchange rates,” Goltermann pointed out. in a research note last week.

“Indeed, over a sufficiently long period of time, this effect often dominates other factors affecting exchange rates, such as relative productivity and the terms of trade.”

The past two decades have been marked by low and stable inflation in many developed markets, unlike a period of high inflation in the 1970s and 1980s when greater disparity occurred between geographies.

Goltermann noted that in general, nominal exchange rates weakened over this period in high-inflation countries, but when central banks tightened policy in response, this led to a temporary but significant appreciation. Exchange rate volatility has been significantly higher in major currencies than in recent years.

Nominal exchange rates indicate the value of the foreign currency in exchange for a unit of national currency, while real exchange rates indicate the value of a country’s goods and services in exchange for those of a foreign country.

United States, United Kingdom, Canada and Australia

Capital Economics has a similar view on the outlook for inflation to that of Wharton finance professor Jeremy Siegel, who told CNBC on Friday that inflation was going to be a “far bigger problem than the Fed thinks” .

Goltermann predicted that among developed economies, the US, UK, Canada and Australia are “more at risk from sustained higher inflation.”

“This suggests to us that their currencies will weaken in nominal terms against the currencies of many European and Asian economies, where we expect inflation to remain subdued.”

In emerging markets, Goltermann suggested that Brazil, Colombia, South Africa, Indonesia and the Philippines risk a pick-up in inflation and currency depreciation, joining Argentina and Turkey, who have already suffered several years of double-digit inflation.

Along with this longer-term deterioration, volatility would likely increase due to heightened uncertainty about inflation outcomes and monetary policy responses, producing larger swings in currency markets, he said. he declares.

“Our baseline scenario is that most policymakers will continue to keep real interest rates low in order to stimulate economic growth and gradually reduce high levels of debt,” Goltermann said.

“But to the extent that some central banks try to reduce inflation by tightening their policies considerably, it could generate more volatility.”


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