Prospect of higher inflation in the US to weaken the dollar over the long-run - Capital Economics

FXStreet notes that the dollar fell by about 5% in trade-weighted terms in July. Some argues that a stronger euro or massive money-printing by the Fed are behind this move lower but Neil Shearing from Capital Economics believes the prospect of higher inflation in the US compared to its peers is the explanation which stands out for the greenback’s weakness. 

“What is going on? Several theories have been advanced. One is that the weakness of the dollar is the flip side of a stronger euro, which has benefitted from signs that European policymakers are finally getting their act together. Yet the dollar has not just weakened against the euro – it has weakened against other currencies too.” 

“Another explanation that has been put forward is that massive money-printing by the Fed, combined with deepening political dysfunction at home and a growing strategic rivalry with China abroad, has reduced the allure of the dollar and hastened its demise as the world’s reserve currency. Yet this is wildly overdone – there is currently no credible alternative to the dollar as a reserve currency.” 

“A more intriguing explanation for the recent dip in the dollar lies in what’s been happening to the inflation expectations that are baked into bond markets. Inflation expectations in most countries have risen over the past month or so, but the rise has been particularly marked in the US. Furthermore, since nominal yields on US Treasuries have remained steady, the rise in inflation expectations has caused a corresponding drop in US real yields. This drop in real yields may in turn have weighed on the dollar.” 

“The rise in inflation expectations could reflect speculation about a regime shift in the US that tolerates – or indeed targets – higher inflation. Admittedly, Jerome Powell made no mention of this in his remarks following last week’s FOMC meeting. But this hasn’t stopped other officials at the Fed from talking regularly about something akin to an average inflation targeting regime – allowing inflation to rise above its target a bit before tightening. We suspect that the Fed’s year-long review of monetary policy, which has been delayed by the pandemic but should conclude soon, could lay the groundwork for such a shift.”