Inflation Dynamics and Recessionary Fears

by Sean Tweedie | July 14, 2022

Inflation Dynamics and Recessionary Fears

Inflation has been a key theme and area of discussion in the financial markets of late.  Rising inflation is a global phenomenon and not centric to the US alone, although investors are paying particularly close attention to inflation dynamics in the US.

What causes inflation?

Simply put, the price of a good or service is determined by the interaction between demand and supply. If demand for a good or service exceeds the supply the price will rise, thereby reducing the demand and restoring balance. Currently, the biggest increase in consumer prices has occurred in areas which have been impacted by supply problems. Much of these supply-side problems stem from the pandemic as well as the conflict in Ukraine.

The US has been battling to keep inflation at bay. See Figure 1. Inflation in the US, as measured by the Consumer Price Index (CPI), jumped to its highest level in four decades at 9.1% on a yearly basis in June from 8.6% in May, the data published by the US Bureau of Labor Statistics showed on Wednesday. This print came in higher than the market expectation of 8.8%. The Core CPI, which excludes volatile food and energy prices, edged lower to 5.9% in the same period from 6% but still surpassed analysts’ forecasts of 5.8%. As economies overheat, markets look to their Central Banks to tame runaway inflation by increasing interest rates.  The Federal Reserve in response to the May CPI print increased interest rates by 75 bps, surprising the market. The June CPI numbers suggest a further interest rate increase by the Federal Reserve which is almost certainly guaranteed at their July meeting.

Inflation in the US, as measured by the Consumer Price Index (CPI), jumped to its highest level in four decades at 9.1% on a yearly basis in June from 8.6% in May

Figure 1

By raising interest rates, the Federal Reserve aims to slow down the economy by making borrowing more expensive. In turn, consumers, investors, and businesses pause on making investments and purchases with credit, which leads to reduced economic demand, theoretically reeling in prices, and balancing the scales of supply and demand. The market fear however is that if the Federal Reserve raises rates too quickly it could stifle economic growth leading to a downturn or worse, a recession.  See Figure 2.

The market fear however is that if the Federal Reserve raises rates too quickly it could stifle economic growth leading to a downturn or worse, a recession.

Figure 2

The dollar continues to strengthen against its peers. This is being driven by expectations of a hawkish Federal Reserve as well as safe haven flows. Year-to-date, the broad trade-weighted dollar and the DXY Index have returned 5.7% and 9.6%, respectively. This relentless dollar strength has sent valuations to significantly elevated levels. Relative to its Purchasing Power Parity fair value, the dollar is now nearly 30% overvalued. See Figure 3. Valuations matter in the long run and point to some downside on a 5-to-10-year horizon. Currencies will revert to their fair value over time, although it can typically take 3 – 5 years to reach fair value. Rising odds of a recession constitute a tailwind for the dollar because the dollar is a counter-cyclical currency that is inversely correlated with global growth.

Relative to its Purchasing Power Parity fair value, the dollar is now nearly 30% overvalued.

Figure 3

If over the coming months inflation is managed to be contained it will allow the Federal Reserve to tone down its hawkish rhetoric and so will not need to hike rates as aggressively. This will mean that the tailwind for the dollar from positive interest rate differentials will begin to fade. Furthermore, if inflation is contained it will allow wage growth to turn positive which will support consumption and allow the economy to avert a severe recession. If recessionary fears are contained, we should see a pivot in investor sentiment which will support riskier assets while weakening the dollar.

For now, inflation dynamics and recessionary fears are likely to keep the dollar strong in the near term. Investors will be watching the Federal Reserve very closely over the coming weeks leading up to the July meeting.

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