Inflation is one of the key drivers of exchange rate movements. Keeping it within an ideal range is one of the great, constant challenges for central banks. Inflation in a country and the associated tools that its central bank employs can have an indirect impact on purchasing power in other currencies.
For inflation movements in countries with major currencies (USD, EUR, JPY, GBP, AUD, CAD, CHF), particularly regarding USD as the world's reserve currency, inflation movements can equate to significant ramifications for other currencies. These include other majors as well as minors, but it is emerging market currencies that tend to feel the brunt of inflation changes in a major economy worst. This in turn can have a drastic change in purchasing power involving the affected currencies.
any prolonged damaging inflationary developments in the U.S. would have global repercussions.
Why U.S. inflation is critical for global exchange rates
A healthy U.S. economy is still a prerequisite for a robust global economy, despite some beliefs, perhaps wishful, that this is no longer the case. The USD still underpins global trade, and as a result any prolonged damaging inflationary developments in the U.S. would have global repercussions. Therefore, excessive U.S. inflation figures - anywhere considerably over the central bank ideal rate of 2% - can either directly or indirectly impact exchange rates around the world.
FX as a driver of purchasing power
To keep inflation from rising too fast, the first weapon in the Federal Reserve's arsenal is to raise interest rates. The U.S. economy is currently in the midst of an interest rate raising cycle, with one more hike expected in 2018, three in 2019, and one in 2020. Interest rate rises attract foreign investment to a currency, helping it to strengthen against others. This makes imports cheaper for U.S.-based companies. U.S. exports on the other hand cost more for overseas companies as their purchasing power is weakened.
Factors that may increase U.S. inflation and affect purchasing power
Recent inflation rates are higher than the Federal Reserve would like them to be. Consumer prices in July, August and September of 2018 were, respectively, 2.9%, 2.7% and 2.3%. And there are certain global developments playing out that could drive inflation higher. The tit-for-tat trade war with China shows no sign of letting up and policymakers at the Federal Reserve recently expressed concerned over its potential negative impact on U.S. businesses and households should it ramp up further.
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The other major issue is with regard to energy prices, the single biggest driver of inflationary pressure. Should oil prices rise, it could tip the global recovery off course. And with the current international crisis brewing over Saudi Arabia's suspected role in the death of journalist Jamal Khashoggi, a price rise is certainly in the cards. Should the West seek to punish Saudi Arabia, the oil-rich state could retaliate by cutting production of the fuel, which would increase prices in the process. It is possible that President Trump may have publicly expressed doubt over Saudi Arabia's role in the journalist's death in order to minimize the likelihood of Saudi retaliation in the form of an oil production cut, such is the level of interdependence in the global economy.
If the Federal Reserve is unable to manage inflation at any point, consumer and investor confidence would fall. This would likely see a weakening of the US dollar, which in turn would weaken U.S. importers' purchasing power and strengthen the position of U.S. exporters and companies importing from the U.S.
Beyond raising interest rates, other recourses include raising capital requirements for banks
Federal Reserve options to reduce inflation and their impact on FX
The Federal Reserve must regularly take action to either grow inflation or keep it from rising to undesirable levels, but its ability to do so is limited and requires a delicate balancing act. Beyond raising interest rates, other recourses include raising capital requirements for banks to restrict consumer spending and increasing interest on government bonds. The former option is likely to reduce the USD's value against other currencies, while the latter would lead to an increase. These measures in turn impact imports and exports, which can have a subsequent effect on inflation.
Inflation is one of the most important drivers of your company's purchasing power on imports or operational costs abroad. It also influences exporter success by impacting client purchasing power. The U.S. is in the middle of an interest rate raising cycle to keep inflation at a sustainable level, but for the longer term, commentators see this as unsustainable. Considering the possibility of further escalations of the U.S.-China trade war and the potential for oil price rises too, maintaining a good inflationary range could be about to become more complex, causing considerable FX volatility and, with it, purchasing power shifts.