Rising inflation in the United States to be quickly imported by other advanced economies. Only during World War II was the monetary and fiscal policy so coordinated as during the COVID-19 pandemic.
The Reserve Bank of New Zealand (RBNZ) is the first central bank that introduced an inflation-targeting mandate decades ago. This year there are five decades since the Nixon Shock – the moment the United States announced the end of the gold standard. What followed was the birth of the free-floating exchange rates, and the RBNZ pioneered inflation-targeting around the 2% area – give it or take 1%.
While achieving inflation is not an issue in developing, frontier, or emerging markets (just the opposite), the advanced economies experienced decades of subdued inflation. Creating inflation around the 2% is viewed as generating economic growth at a sustainable rate.
Yet, 2% inflation, while a target for most developed nations, was difficult to achieve. The curious case of Japan is still open, as the central bank is not able to achieve its target for more than two decades now. Some other central banks struggled in the process, such as the European Central Bank that sees the inflation rate well below 2%.
But the COVID-19 pandemic changed things. The central banks and governments’ response triggered a sharp increase in inflation expectations. This, in turn, led to the actual and projected inflation to rise significantly.
Euro Area Inflation Lags the US Core PCE Inflation
Trading the currency market often means interpreting the differences between the two economies that the exchange rate represents. For instance, in the case of the EUR/USD exchange rate, the pair often moves based on the differences seen in the actual economic data. Thus, traders speculate using their analysis and interpretation, buying or selling one currency against the other.
If we use the inflation data solely, as inflation is the main topic in financial markets right now, we see the Euro area inflation lagging the US inflation – the Core PCE data is the Federal Reserve’s favored way of measuring inflation.
Normally, it means increased expectations of a higher EUR/USD in the months ahead. After all, higher inflation in the United States should be reflected in the US dollar’s strength.
Yet, financial markets work differently. They tend to react to growing expectations that the Fed will start tightening the monetary policy to avoid rampant inflation. Hence, the US dollar might actually get stronger despite higher inflation in the US when compared to the Euro area.
One thing is for sure. The US fiscal and monetary policy was as coordinated as in 2020 only during World War II. Because the US is the largest economy in the world, expect other economies to import the higher inflation sooner rather than later.