Dollar Volatility and Inflation

November 22, 2021

The acceleration of inflation in 2021 has been broadly experienced across the world and remarkable in its suddenness. Year-on-year inflation rates last December were both low and more tightly bunched than now. In the cases of Japan, Switzerland and the euro area, inflation was lower than zero back then at -1.2%, -0.8% and -0.3%, respectively. For an array of other economies where inflation ended 2020 in positive territory, it was still below the 2.0% threshold that is generally associated with a condition of price stability. Those December inflation rates ranged from 0.2% in China upwards to 0.5% in Sweden, 0.6% in Great Britain, 0.7% in Canada, 0.9% in Australia, 1.4% in the United States, and 2.4% in Poland. Unlike the early days of floating foreign exchange rates, the existence of higher inflation in the United States than those other countries was a dollar positive, since the United States was closer to an optimal state of price stability (i.e., 2.0%) than other economies.

To be sure, a number of economies even at end-2020 were experiencing inflation well above 2.0%, such as Mexico (3.2%), the Philippines (3.5%), Brazil (4.5%), India (4.6%), Russia (4.9%), Turkey (14.6%) and Argentina at 52.1%. But investors weren’t focused on inflation in 2020, and relative inflation rates weren’t a driving force in foreign exchange for the most part.

In 2021, inflation rate have climbed, becoming more spread out and more closely watched by investors. The latest CPI inflation rates in Japan, Switzerland and Euroland stand at 0.1%, 1.2%, and 4.1%. U.S. inflation has accelerated more than fourfold to 6.2%, and Canada’s 12-month CPI increase is up four percentage points to 4.7%. British CPI inflation has risen seven-fold to 4.2%, and in Australia, such has tripled from 0.9% to 3.0%. Chinese inflation is now at 1.5% versus 0.2% ten months ago. Swedish inflation is nearly sixfold higher now at 2.8%, and the inflation rates of Mexico and Brazil have roughly doubled to 6.2% and 10.7%. Russian inflation has climbed to 8.1% from 4.9%, Turkish inflation is now pressing against 20%. India is a rare case where inflation is lower now (4.5%) than then (4.6%), but Argentine CPI inflation has advanced from 36.1% to 52.1%.

Theory and historical experience suggest that if inflation around the world proves not to be a temporary as most central bankers have until recently believed, currency market volatility is likely to pick up. This hasn’t happened so far in 2021. High/low ranges year to date in the dollar have been held to 6.7% against sterling, 6.9% relative to the Canadian dollar, 8.0% versus the Swiss franc, 9.8% vis-a-vis the euro, 12.0% versus the yen, and 12.7% against the Australian dollar.

These trading bands are small by the standards earlier in the era of flexible dollar exchange rates. The weighted dollar index (with weights of 57.6% for the euro, 13.6% for the yen, 11.9% for sterling, 9.1% for the Canadian dollar, 4.2% for the Swedish krona and 3.6% for the Swiss franc) shows a year-to-date appreciation of just a little more than 7.0%, and that 7.3% rise basically defines the U.S. dollar’s whole trading boundaries, as the 2021 low was set on January 5, and the high occurred today. By contrast the weighted dollar soared 91% between end-1979 and early March 1985 but then slumped 48% in less than the ensuing three years.

The fact that the dollar has been well-bid this year is also interesting, because the high inflation of the 1970s not only destroyed the previous system of fixed dollar rates but also resulted in considerable dollar depreciation between 1970 and the end of 1979. Like then, U.S. inflation is higher now thanĀ  in the countries that acquired “hard currency reputations.” President Biden’s voter approval ratings are well down largely because of the sharp rise in U.S. inflation, and the financial press and political pundits in Washington have spoken in alarming terms about the Fed’s response to inflation. But investors appear to remain confident that inflation will be slain and at at much lesser economic cost this time than was the case several decades ago. Not only the dollar but also U.S. Treasury yields continue to signal a vote of confidence in the Federal Reserve.

Two countries where high inflation is clearly feeding into currency behavior are Argentina and Turkey. The peso has slid from 85 per dollar at the start of this year to over 101 per USD, and the Turkish lira has fallen to 11.48 per dollar from its 2021 low of 6.96 in early February. Central bankers all over have been warning that inflation will recede more gradually than thought initially and that it will take longer into next year, if not later, for a semblance of price stability will be restored. A big wild card in 2022 is how much patience investors will demonstrate in the absence of significant progress toward the goal of price stability.

Copyright 2021, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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