Two ways to understand High Inflation

Not long ago, central banks struggled to get inflation rates up to a 2% target in the medium or long term. And under this policy we saw interest rates at 0% and an expansion of the balance sheets of the monetary authorities.

Today, inflation is unleashed. We are seeing rates of price increases not seen in decades. Specifically, inflation in the Eurozone has reached a record for the sixth consecutive month, raising new questions about the reaction of the European Central Bank. Headline inflation in the 19-member region reached 7.5% in April.

On the other hand, from the United States the annual inflation rate accelerated to 8.5% in March 2022the highest since December 1981.

Price growth has been unleashed, and there is a certain degree of inability on the part of the main central banks to forecast these conditions because they have gone well above the official objectives. Now the fear is that inflation will take hold.

On this point, the ECB and the Federal Reserve are adopting disparate reactions in their respective monetary policies to try to tackle the problem, since there are two ways of understanding high inflation.

The ECB: Interest rates are not touched for now

First, the ECB continues with the monetary policy of expanding the balance. Net purchases under its asset purchase program should be completed in the third quarter. The monthly net purchases have had an amount of 40,000 million euros in April, and will have an amount of 30,000 million euros in May and 20,000 million euros in June.

And in terms of interest rates, it is not touched. They remain stuck at 0%, while other major central banks are betting on raising interest rates. The interest rate on the main financing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0%, 0.25% and −0.50%, respectively.

The ECB makes a vague expectation about the tightening of its monetary policy: “Any adjustment of the ECB’s official interest rates will take place some time after the end of net purchases” How long? It is unknown.

As we can see, the ECB does not seem to be taking the price rise very seriously. Y within the central bank the positions are divided.

Part of the ECB believes that ** raising interest rates immediately would mean causing a recession after the latest weak data on the economy of the Member States **. At the same time, for the states that are highly indebted, not fighting inflation is a way to devalue them, passing the bill to the economic agents that are saving.

Other positions point to the problems that high inflation will generate throughout the economy are greater than the risks of recession. In addition, as we will see at the end that the United States is already raising interest rates, has an impact on our foreign exchange market.

The Federal Reserve begins its fight against inflation

The US central bank has a much clearer view of what needs to be done and in its latest bulletin it says the following: “With adequate firmness in the monetary policy stance, the Committee expects inflation to return to its 2% target and that the labor market remains strong In support of these goals, the Committee decided to raise the target range for the federal funds rate half a percentage point up to 1% and anticipates that continued increases in target range will be appropriate.”

This rise is the highest in 22 years and it’s the second rate hike in a row, aimed at tackling runaway inflation. Normally there are increases of 0.25 basis points, which gives us an idea that there is some concern to fight prices.

Not only is there more speed in attacking inflation, but expectations of rate hikes are much more aggressive compared to their European counterpart. Fed Chairman Jerome Powell acknowledged that high inflation requires aggressive action, opening the door to additional rate increases of 0.5% unless inflation falls rapidly.

In fact, market prices of interest rates reflect investor expectations of 0.5 basis point rate hikes at each of the next four Fed meetingswith an implied 2022 year-end rate just above 3%, up from 0.08% at the beginning of 2022.

In relation to its unconventional monetary policy, while the ECB widens its balance, The Fed will start reducing its $9 trillion asset holdings on its balance sheet on June 1. The plan will start with a monthly reduction of 30 billion in Treasuries and 17.5 billion in mortgage-backed securities for 3 months and then increase to 60 billion and 35 billion in mortgages per month.

The shadow of the exchange rate

Normally in the bulletins in which the actions of the monetary authorities are collected there is no tendency to mention the evolution of the exchange rate since, in principle, it is not part of the key objectives to be achieved by a central bank.

However, in a global environment exchange rates matterand a lot, especially when we refer to the main currencies traded, such as the dollar and the euro.

When the Federal Reserve increases interest rates, it leads to an attraction of capital, since the risk-free asset will be better paid for investors. This is reflected in the dollar index that carries a rise of 7.92% so far this year, up to 103.63 points.

However, this action can generate a series of detrimental effects in the rest of the economies mainly those of emerging and developing economies around the world in the form of currency crises.

Global investors sell their investments denominated in their local currencies in exchange for investments denominated in US dollars. The result is a stronger exchange rate in favor of the US dollar and a sharp devaluation of the local currency.

In the case of the euro, it does not seem that we are witnessing or are going to witness a currency crisis. But yes, the ECB must be attentive and must methodically analyze the evolution of the exchange rate after the euro fell to a five-year low of $1.05fueling inflation by pushing up import prices.

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