At the beginning of 2020, the US government, together with the Federal Reserve, has implemented a series of unprecedented measures in an effort to support the economy hit by the COVID-19 pandemic. The Trump administration introduced the largest stimulus package in history, while the Fed cut the interest rates to record lows again (the first such move followed the 2008 financial crisis) and initiated its quantitative easing (QE) policy, basically injecting free money into the economy to encourage consumption and business investment.
While these measures have encouraged a quick recovery of the US economy, they led to some unwanted effects, the most important of which is high inflation. The latest geopolitical tensions, with Russia invading Ukraine at the end of February, have added gas to the fire, with prices of many commodities surging to record levels. The consumer prices index (CPI), which is the key inflation gauge for the US economy, surged 7.9% in February compared to the same period in 2021. This is the highest figure in four decades, and economists don’t expect the pace to have slowed down in March.
Inflation is a measure that monitors the rate of rising prices of goods and services. Most developed countries leave some room for inflation to take place, with the Fed and other central banks targeting a 2% annual inflation.
There are several reasons why high inflation may occur. In the case of the US, surging inflation is the result of the expansion of monetary supply, as the Fed deployed its QE, as well as increasing commodity prices due to supply chain bottlenecks and geopolitical sections. Inflation makes the national currency less attractive because it points to a gradual devaluation of money. Still, the US dollar has managed to withstand the pressure from counterparts like the euro, as the European Union (EU) itself is struggling with surging inflation because of similar reasons. Besides this, the greenback has often benefited from its world reserve status to act as a reliable safe haven amid geopolitical tensions that are directly affecting Europe in the first place.
The accelerating pace of inflation is forcing the Fed to consider raising the interest rates sooner than initially planned – a situation that favors the US dollar, as higher rates benefit savers and thus make the national currency attractive. Therefore, inflation alone is a bearish signal for the American currency, while a more hawkish Fed is bullish for the greenback. The dollar has been driven by these two main factors in the first half of 2022.
Inflation to Maintain High but Slow Down in the Coming Months
In the first month of the pandemic, it was clear that the Fed’s unprecedented measures would lead to a higher level of inflation, but the central bank had constantly reiterated that it was a temporary issue. However, the Fed seems to have failed with its assessment, as inflation has got even worse, causing trouble to the US economy.
For example, in February, inflation-adjusted consumer spending contracted, highlighting the pressure on demand for goods and services.
After a 7.9% surge in February, analysts expect the March CPI to come in at over 8.5%, although the consensus suggests that this is the peak and that the pace will start slowing down in the coming months. Official data for March is scheduled for April 12.
Swiss investment bank UBS warned that inflation would come in at 8.5% in March, which would be the highest level since December 1981. UBS estimates are relevant given that they have been more accurate over the past year compared to Wall Street consensus forecasts, which tended to be more moderate. Inflation data has repeatedly surprised markets to the upside.
Traders price in an even higher inflation figure for March, as derivative-like instruments known as fixings suggest that the CPI would come in at 8.6% in March.
Fed Turns More Aggressive on Inflation
During its latest meeting in March, the central bank has increased the interest rate by 0.25% to a range between 0.25% and 0.50%, making no changes to its QE pace. This was a weak signal for the markets, with analysts arguing that the Fed failed to show its determination on time.
Speaking about the Fed’s latest decision, Gang Hu, a TIPS trader with New York hedge fund WinShore Capital Partners, said:
“Unfortunately, this might have been the time that the market and society needed a shock-and-awe showing the Fed is still very focused on holding inflation down. To hike rates by 25 basis points, with no quantitative tightening, has almost put fuel on the fire. Main Street is saying, `We can raise prices however we want to, without regard to competition.’ So far, it is right.”
Nevertheless, the minutes of the March meeting, published at the beginning of April, showed that the Fed was finally ready to turn more aggressive by considering larger rate hikes and greater reduction of its $9 trillion balance sheet. The cuts will be $60 billion in Treasury securities and $35 billion in mortgage-backed bonds per month, which is more categorical than anticipated.
In fact, the minutes showed that “many participants noted that one or more 50-basis-point increases in the target range could be appropriate at future meetings, particularly if inflation pressures remained elevated or intensified,” but the geopolitical tensions related to Russia and Ukraine called for a more cautious approach.
On April 7, St. Louis Fed President James Bullard, who is regarded as a more hawkish member of the Fed’s Federal Open Market Committee (FOMC), admitted that inflation was too high and the central bank had to act. The minutes show that Bullard called for the highest rates among his peers, aiming for 1% hikes by June. He stated:
“US inflation is exceptionally high, and that doesn’t mean 2.1% or 2.2% or something. This means comparable to what we saw in the high inflation era in the 1970s and early 1980s. Even if you’re very generous to the Fed in interpreting what the inflation rate really is today … you’d have to raise the policy rate a lot.”
The Fed’s more hawkish rhetoric coming from the latest minutes and the FOMC members have supported the US dollar, with the USD Index expanding to the highest in two years at 99.832.
Fed’s Rate Hike May Contribute to Recession
The US central bank is in a difficult position today. While it has to tighten the monetary policy to address the surging inflation, the upcoming rate hikes may put pressure on economic growth. In other words, rate hikes are a double sword for the US dollar. For now, the tighter policy will surely support the national currency, which already happens, but a recession wouldn’t bode well for the greenback.
Deutsche Bank is the first banking giant to warn that the Fed’s plan to aggressively reverse the easy monetary policy is leading to recession. On Tuesday, CNN reported on Deutsche’s recession forecast. The bank’s economists led by Matthew Luzzetti said:
“We no longer see the Fed achieving a soft landing. Instead, we anticipate that a more aggressive tightening of monetary policy will push the economy into a recession.”
While Deutsche said that there was considerable uncertainty regarding timing, a mild recession could be arriving at the end of next year, with unemployment peaking at 5% in 2024.
Elsewhere, JPMorgan CEO Jamie Dimon identified three main forces impacting the global and US economies, which are the quick economic recovery from the Covid pandemic, high inflation, and geopolitical tensions. He said that the confluence of these factors might increase the risks ahead. Dimon said:
“The war in Ukraine and the sanctions on Russia, at a minimum, will slow the global economy — and it could easily get worse. That’s because of the uncertainty about how the conflict will conclude and its impact on supply chains, especially for those involving energy supplies.”
While the risks of recession persist, the US dollar has strong support from a more hawkish Fed for now, and the American currency would likely consolidate its position against the euro. The next rate hikes and messages coming from the Fed would probably give bulls more courage.