By Gaurang Somaiya
Inflation may be an unavoidable phenomenon but it is starting to make a lot of people nervous. Most market participants believe that inflation is primed for rapid acceleration as trillions of dollars have been pumped by the Federal Reserve along with near-zero interest rates. But now, the question arises whether inflation will be modest. Will it be a managed wave or a dramatic flood that will roil the financial markets.
There are also some who aren’t overly concerned that inflation will spiral out of control, especially since the US economy has plenty of post-pandemic ground to regain.
Inflation has been too low for too long
In general, the government mandates the central bank to foster employment and maintain price stability. The Federal Open Market Committee (FOMC) has interpreted maintaining price stability as keeping inflation growing at about 2 per cent a year over the long term.
Using the Fed’s preferred gauge of inflation, the core personal consumption expenditures (PCE), which track the price changes over time without volatile energy and food costs, inflation has remained stubbornly below the US central bank’s 2 per cent annual target since the Great Recession, except for a brief stretch in early 2012 and much of 2018.
But does higher inflation raise expectations of higher interest rates? At this point, the answer is no. But that may not always be true and does not mean that the Fed will not look to raise rates. In early 2018, inflation in the US had managed to top 2 per cent. That was more than two years after the Fed had already begun a campaign of gradual rate increases.
Rising fear of inflation, but all of a sudden?
It suddenly seems that worrying about inflation has gone mainstream and the recent CPI number from the US just brought it more in focus.
The Federal Reserve is always known to prepare the market beforehand, and the recent comments by the Treasury Secretary and the Fed Chairman suggest that they are worried about rising inflation but are not panicking at this point in time.
Officials have so far emphasised that this is a temporary surge, driven by pandemic-related shortages and supply-chain disruptions. So, there is no need to raise rates suddenly in response to it.
The view that inflation is transitory is reasonable given the challenges associated with bringing the entire US economy back online after an unprecedented shutdown. Yet precisely because this situation is unprecedented — both in the scale of the economic downturn and the size of the government response — it is impossible to tell how large the spike in inflation will be, or how long it must take the US economy to get through it.
Commodities and inflation
When it comes to inflation, the alarm bells are ringing louder with the commodity markets shattering records and governments continuing to pile on stimuli. Expectations of price pressures are apparent in the commodity markets, with iron ore, copper, aluminium and other metals either soaring or nearing record levels.
Lumber prices have also hit record highs while corn and wheat prices are on a tear. But the question arises: Does inflation accelerate because of a rise in commodity prices? Again, the answer is no. Commodity prices and consumer inflation are quite different phenomena.
Basic commodity prices no longer have any significant effect on long-term inflation. Consumer inflation figures are based on the prices consumers pay for the things they ordinarily buy directly. Consumers do not buy commodities directly. They buy manufactured consumer products. Commodity prices affect consumer prices indirectly, and partially. For many of the products people buy today, commodities constitute a very small percentage of the manufactured cost, and an even smaller percentage of the retail price.
Most manufacturers do their best to smooth out commodity price fluctuations, absorbing some costs during the period of rising prices, and enjoy margin improvements during downward moves, keeping the prices to their customers more stable. As a result, commodity prices are much more volatile than CPI.
The impact of inflation on dollar
Higher inflation isn’t necessarily a bad thing for the average American. When inflation runs high, workers are empowered to ask for bigger raises to keep up with the cost of living, and debt holders get a break on their obligations as their borrowed money becomes comparatively less valuable. But life becomes a little more complicated for savers and retirees living on fixed income, as inflation erodes the purchasing power of every dollar.
Democrats seem to have finally become tired of the one-sided game, where Republicans run up a debt, but still get credited as the party of fiscal responsibility; now, both parties seem more content to let deficits go up. That could be a real regime shift.
It could take only a modest bump in inflation to get the ball rolling. Right now, one reason prices are rising is that the US economy is having difficulty adjusting to the end of the pandemic.
As consumption patterns shift, there will be acute shortages in the things people suddenly want to buy more. Inflation soared and so did market volatility.
In addition to a large and increasing deficit, the US government has a large existing stock of debt — about $21.7 trillion, or just over 100 per cent of GDP. Because interest rates have been low for a while, the federal government doesn’t have to make big interest payments on that debt. If government interest payments go too high, the US would have to hike taxes, cut spending or borrow even more to cover the greater interest costs.
If the US government, fearful of a recession, chooses the even-more-deficits option, that could raise inflation even more and force the Fed to hike rates yet again.
So higher inflation could force the Fed to raise rates, which may have a positive impact on the dollar.
The scenario may take some time to take shape and the timing of rate hikes is surely a difficult question, but we can conclude that losses for the dollar could be limited.
On the downside, we expect the dollar to find support at 88.50 and until the level is held, the momentum could take it higher towards 93.50 and 95.
(Gaurang Somaiya is Forex & Bullion Analyst at