Why Does The USA Have High Inflation in 2022?
Aug 16, 2022
Back in February 2022, the US Bureau of Labor Statistics reported that the current inflation rates based on the Consumer Price Index (CPI) stood at 7.9%. This has been the highest it’s been in the last 40 years. This is primarily the result of the demand and supply-side distortions brought about by the COVID-19 pandemic.
Although those distortions have slowly started to normalise again in 2022, the inflation rate seems to still be at an upward trend and is currently at 8.5%. This can be potentially problematic as interest rates are quite likely to skyrocket as the CPI goes up. Let's look at what causes the inflation rates in the US to go as high as it is now and how they will affect the foreign exchange market.
Why US Inflation Rates Are So High Right Now
Much of the surge in prices was actually brought about by the COVID-19 pandemic and the US government's response to it. The US economy, along with most of the world's economies, was practically paralysed by the pandemic due to the lockdowns in the US, other developed countries, and many parts of the world.
Moreover, the US government imposed stringent travel and trade restrictions in an attempt to contain the spread of the deadly pandemic. The problem with that is that the travel and trade restrictions, although necessary, serve to artificially increase the demand for goods and services. This happens in economies that were already in the late stage of the business cycle bubble. The economy had been forecast to sink into a prolonged downturn, but it surprised everyone by staging an unexpected recovery, although it was short-lived. After a series of government bailouts and emergency Fed stimulus measures, the economy turned around in spring and injected billions of dollars into the economy, propelling consumers to return to restaurants, bars, shops and airports.
When COVID-19 spread around the globe in 2020, the demand side of the economy faced a steep decline. As a result, businesses were forced to cut back on staff in order to streamline their operations, which in turn caused consumer confidence levels to plummet. Businesses were left with little choice but to close their doors to the general public and even each other in an attempt to contain the spread of the virus and minimise the possibility of more employees being infected. The tightening of the global supply of goods and services, coupled with a scarcity of supply, resulted in an increase in the price of goods and services, further exacerbating the situation.
On the supply side, the production of goods and services has been constrained due to the massive death toll caused by the virus. Many of those that survived were forced to retire from their professions.
However, in the spring of 2022, vaccines began rolling out, which bolstered consumers' confidence to return to restaurants, bars, shops, and airports for their travel needs. As a result, we have seen a surge in business. Although the recovery of consumer and business confidence has helped lead to a revival of the United States' economy, the demand-side distortions have not fully recovered. This has then led to a surge in inflation, which is primarily a consequence of the recovery of the United States' economy.
The Ukraine-Russia Crisis
Over the months since the crisis in Ukraine began, the prices of imported goods have increased, contributing to a rise in inflation. The continued pressure on the dollar and the oil price hikes have added to the inflation rate woes. This has led to a rise in inflation expectations, which has, in turn, led the Federal Reserve to continue with enacting currency-weakening policies to keep the dollar stable and interest rates low.
In an effort to prevent the conflict, the US and European Union both imposed sanctions against Russia, which has hurt Russia's economy. This has caused Russian companies to sell their products at a lower price than what they could typically sell them at, which has caused the price of certain products to decrease in price while the overall level of inflation has remained the same. These products include oil, precious metals, and steel.
The US is currently the world's biggest importer of crude oil, which it buys from Russia, Canada, and Saudi Arabia, among others. Currently, Russia accounts for about 10% of global petroleum production, while the US imports about 8% of its oil from Russia. Because of the import ban on Russia, the United States has been forced to buy oil from Saudi Arabia instead.
At one point, the price of oil went up to $139 per barrel, making it the highest for almost 14 years. On the other hand, wholesale gas prices more than doubled.
Oil is one of the largest traded products in the world, and it's imperative that the United States can procure it from the US dollar. This is because oil is priced in US dollars on the global market. The fact that the United States is forced to buy more oil from Saudi Arabia instead of Russia has increased the demand for US dollars, lowering the value of the ruble and increasing the value of the US dollar. This has, in turn, caused inflation.
Dealing with the Crisis
Now, the general expectation is that the US Federal Reserve will continue to raise interest rates over the years to come in an attempt to control and tame the inflation rate. With inflation reaching as high as it currently is, the demand for dollars is going to remain strong while the demand for other currencies will be relatively low. The only way to balance out the supply and demand is to see the prices of other currencies rise in response to the rise in demand for the dollar.
Thus, the increased demand for oil and the resulting higher prices will have a strong impact on the global foreign exchange market.
How The Inflation Rate Impacts the Foreign Exchange Market
When the inflation levels in the United States rise, the interest rates in the United States will follow along. Since the Federal Reserve Bank is tasked with maintaining price stability as well as a positive output gap, it will intervene in the foreign exchange market to maintain a stable exchange rate. It's possible that the Federal Reserve Bank may be hesitant to raise its federal fund's rate above the target range of 2.25 - 2.50% due to the current economic recovery and the fact that its target inflation rate is currently at just 2.1%. However, the continued increase of the CPI may force the Fed's hand to raise interest rates for the first time in a decade.
It's also interesting to note that a rising interest rate in the United States means that the price of a dollar will increase. As a result, the dollar will be in higher demand than other currencies, which is a positive for the US dollar. If the supply of foreign currencies is constrained, the price of foreign currencies will rise as well.
Why the CPI Matters to Currency Traders
For currency traders, the importance of the CPI is that it is the main source of information on inflation. The Federal Reserve Bank uses the CPI to formulate monetary policy, which also allows traders to forecast inflation. By forecasting inflation, traders will be able to determine the direction of the US dollar and thus, make better decisions on Forex trades.
As the Federal Reserve Bank adjusts interest rates in response to changes in the CPI, currency traders can make a profit by converting the currencies at the current rate and then reliquifying them at the higher rate.
As more and more currencies move with the rising interest rate, the Forex market will begin to experience increased volatility. This is due to the fact that it will be more profitable for currency traders to convert the currencies of the countries they trade with while they still can.
Inflation and the Exchange Rate
Markets have been gripped by the debate as to whether higher inflation is here to stay or is it purely transitory, and analysts have suggested the outcome could have significant repercussions for currency markets.
In recent weeks, there has been a lot of debate over whether higher inflation is here to stay. While inflation is the default option of central banks in times of crisis, it could have significant ramifications for currency markets.
With US inflation projected to continue to rise above the current level this year, a range of economists has suggested the Fed should embrace the higher inflation rate. It could be the path to stronger economic growth. In theory, inflation should help lift wages and spending, and a stronger economic backdrop would, in turn, help the dollar.
In the short term, this could be bad for the dollar, which could suffer as investors pile into other currencies.
Over the longer term, the Fed's strong anti-inflation reputation could be dented if it fails to respond or over-responds to the new inflation environment.
What's Next for Inflation Rates
The major concern for investors is that the rise in inflation will lead to a rise in interest rates. This would then lead to the devaluation of the US dollar in the long term, which would, in turn, hurt the US economy. The United States would lose its status as the world's reserve currency, which would inevitably lead to an economic downturn.
With the US dollar losing strength, investors are likely to look for other currencies to park their capital in. This would then lead to a flood of capital into other currencies, which would, in turn, lead to increased demand for those currencies. This would push their prices up, which would, in turn, further bolster their appeal.
The US Federal Reserve is the world's major central bank, and it will ultimately be tasked with the job of steering the global economy during this time of higher inflation.
As inflation and rising rates have been a concern for investors, the Federal Reserve will be forced to consider intervening in the currency market to maintain the value of the dollar. By purchasing foreign currency and selling USD in the currency market, the Federal Reserve could place a lid on the rising USD-denominated prices. However, if the Federal Reserve Bank raises its federal funds' rate above the 2.25 - 2.50% target range, it will prove to be a bullish sign for the US dollar.
What the Future Holds
The Federal Reserve Bank has been trying to get the inflation rate back to its target of 2.0% for the past eight years. The dollar had been gaining in value until earlier this year when the Fed's policy of quantitative easing caused investors to increase the demand for dollars and decrease the demand for other currencies. However, this reversal of fortune due to the increase in US inflation is a positive sign. It means that the Fed will likely continue on a path to increase the inflation rate until it reaches its target.
The most important takeaway from all of this information is that the possibility of an economic downturn is real. Investors should be aware of the increasing demand for the dollar, the increasing inflation rate, and the increasing interest rates. If the Federal Reserve Bank continues to raise interest rates, it's likely that the dollar will strengthen. However, this is only likely to be a short-term trend as the dollar continues to face a strong possibility of losing its status as the world's reserve currency.
Inflation has become a growing concern for investors, as it has the potential to destabilise the entire global economy. It has been a threat to the US economy for quite some time, and the Federal Reserve Bank has been trying to establish a rate of inflation that would be sustainable over the long term. After almost a decade of inflation below the target set by the Federal Reserve Bank, the US inflation rate has finally begun to rise. Even a small increase in the inflation rate for the US economy could lead to a significantly higher interest rate, which would, in turn, lead to an increase in the value of the dollar.
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