One of the paradoxes created by the pandemic is the low level of inflation despite huge intervention from central banks and governments. Inflation, part of every modern central bank’s mandate, fails to show its teeth, proving once again that there is a huge difference between economic theory and practice.
In theory, central banks can create inflation by printing money. Because a central bank acts as a banker to the government, it has the power to create unlimited amounts of money. The secret is to find the right balance between economic growth and the money supply (i.e., the quantity of money in an economy) so that inflation remains constant and close to the target. The economic consensus is that sustained economic growth can be achieved by having moderate levels of inflation – below but close to 2% for most central banks in the world.
Fed Expects Higher Inflation
The last Fed meeting of the previous year revealed that the Fed expects inflation to overshoot the target in 2023. While it may seem far away in the future, the key here is how much will the Fed let inflation run.
The recent shift to Average Inflation Targeting (AIT) was one of the boldest moves ever triggered by the Fed. It also represents the biggest unknown to the markets as to what the dollar’s reaction will be.
Will the Dollar Weaken?
Not necessarily. Higher inflation translates into a weaker currency, but the issue here is the benchmark. The currency market is formed out of currency pairs that reflect the value of one currency in terms of another. If inflation leads to a weaker currency, automatically, it means that other currencies will strengthen against the dollar.
However, all central banks in the developed world reacted in a similar fashion as the Fed did. They printed money and engaged in quantitative easing programs. In other words, a currency pair will end up reflecting the difference between the inflation expectations of the two countries (regions) involved. In other words, if inflation in the United States jumps to 3% but in the United Kingdom, it jumps to 5%, what will be the future direction of the GBPUSD pair?
To sum up, everyone agrees that inflation is coming, but we are yet to find out what will be the effect on the FX dashboard. Higher inflation does not lead to a weaker currency if inflation rises everywhere in the world.