In March 2021, we published an article Is Inflation set to rise? about the risks of a shift from a deflationary to inflationary model, in light of the Covid-19 recession, and the impact for investors. Three months later, the main question on investors’ minds remains if and when inflation will take off.
As America’s economy bounces back from the pandemic, stimulated by trillions of dollars of fiscal stimulus, the risk of a price surge is even more acute than before.
In the US, the core personal consumption expenditure index, which excludes volatile food and energy costs, rose by 3.1% in April 2021 compared to April 2020. The surge represents a sharp increase compared with the 1.9% annual rise in March and was higher than the general consensus. The comparative level of April 2020 is certainly low due to the first coronavirus lockdowns, but since the re-opening of the economy, we have observed a rise in demand coupled with supply chain bottlenecks that are definitely putting pressure on price. Prices are rising in all many major economies, not only in the US.
Commodity prices are rising all across the board, from corn to copper and house prices have recently accelerated, probably due to the imbalance between demand and offer, but also as a result of speculative excess creeping into housing.
The unprecedented monetary expansion (see graph below) and fiscal support is first flowing into the financial market and may explode into inflation. Concern over excess US demand contributes to the jittery of the equity market. The gap between returns for stocks and fixed income investments continues to push investors towards riskier outlets in the equity markets.
Total money supply in the US
The supply of money in the US has doubled since the beginning of the pandemic.
Source: Federal Reserve (Aug 2007 - May 2021)
It seems like both the Fed and the White House expect the pickup in inflation to be temporary but financial markets doubt it will be for a short period of time. They are pricing a growing risk of a prolonged period of inflation above the Fed’s target and the possibility of higher interest rates in 2022.
What would be the impact of an inflation spike on the dollar?
As inflation is expected to spike in the next few years, consequently to the US money supply explosion, how will the dollar be impacted?
The dollar dominance, as a reserve currency, will be impacted: there are already signs that the dollar’s dominance is slipping and that the world has moved gradually towards a multiple reserve currency system. We are witnessing a shift away from the dollar as the global reserve currency, a competition in which bitcoin and other digital assets play a major role. China’s development of a central bank digital currency could also be a concern for the dollar’s use internationally.
According to the IMF, the share of US dollar reserves held by central banks fell to 59% during the fourth quarter of 2020 — its lowest level in 25 years. This compares with a share of 71% when the euro was launched in 1999. The IMF’s article, “US Dollar Share of Global Foreign Exchange Reserves Drops to 25-Year Low”, shows that exchange rate fluctuations can have a major impact on the currency composition of central bank reserve portfolios. The dollar exchange rates are influenced by several factors, including the differences in monetary and fiscal policies.
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