Global central banks are racing to raise interest rates to combat surging inflation. How far and fast each major central bank moves is the short-term driver in foreign exchange rate markets. The US dollar’s developed-market peers, led by the euro, pound sterling and Japanese yen, are falling against the US dollar. Many emerging markets are also feeling the heat from the strength of the US dollar.
Inflation rages on
Although US consumer price index (CPI) inflation moderated to 8.5% year-on-year (YoY) in July from 9.1% in June, the debate continues between those who see inflation remaining high and others who believe it to be transitory. Federal Reserve (Fed) Chair Powell’s recent comments have kept alive the possibility of a 75bp rate increase at the meeting of the Federal Open Market Committee (FOMC) on 20/21 September.
Meanwhile, annual inflation in the eurozone – which edged up further to 9.1% YoY in August from 8.9% in July – is now higher than in the US.
Europe has a bigger inflation/growth dilemma than the US. The energy shock is afflicting Europe far more than the US, leading to concerns that the European Central Bank (ECB) will not be as resolute as the Fed’s in tightening monetary policy.
The challenge is similar in the UK, where surging inflation is prompting the Bank of England (BoE) to increase interest rates sharply, despite a rising risk of recession. Indeed, the BoE has already incorporated a recessionary outlook into its rate hike policy path for the rest of the year.
Worryingly, inflationary pressures are broadening out, with core and services inflation items rising sharply everywhere (Exhibit 1). In the US, accelerating wages are feeding into rising prices, notably in consumer services. Europe may soon face the same situation.
The exception is China, whose sub-3% inflation rate is one-third of that in the developed world (Exhibit 2). Thanks to its relatively closed capital account, this inflation differential allows China to pursue looser monetary policy in contrast to the policy tightening in the developed world.
The relative pace of tightening
With the Fed seen as having the most aggressive tightening policy among the major central banks, alongside more resilient economic growth, the US dollar has kept on rising. The Japanese yen (JPY) continues to fall against the US dollar, having depreciated by a fifth this year, surpassing the psychologically important level of JPY 140 against the US dollar for the first time in almost 25 years. The yen could yet weaken further given the divergence between the increasingly hawkish Fed and the ultra-loose stance of the Bank of Japan.
Meanwhile, the US dollar index (DXY) is trading close to 110, its highest since January 2002. The market is evidently not impressed with the pace of the ECB’s rate increases, especially as the Fed is expected to raise rates by a further 75bp this month.
Even if the ECB were to decide on a large rate rise – for example, of 75bp – it is unlikely to reverse the euro’s negative trend because Europe’s difficulties are mainly related to the energy crisis. Some European policymakers are more concerned about recession than inflation and favour a moderate rate hike of 25bp.
The policy of the new UK Prime Minister, Liz Truss, may seek to slow the BoE’s pace of monetary tightening and focus on growth. The pound sterling fell to a fresh low against the dollar on Monday 5 September on the news of her being confirmed as the new prime minister, before recovering on profit taking.
In contrast to these central banks, China will continue its policy easing. This will likely translate into more short-term downward pressure on the renminbi exchange rate. Together with a lack of high inflation in China, a weaker renminbi will transmit deflationary pressure to the world, counteracting some of the global inflationary pressures.