Dubai: We hear the words ‘inflation’ and ‘recession’ more often now than before, but do they really warrant any merit? The way currencies are plunging worldwide is, sure enough, a sign that they do.
While inflation is the dominant source of stress for most economies worldwide, what most often goes unnoticed notice is that it’s really currencies that are putting the most pressure on central banks.
Inflation is a loss of purchasing power over time, meaning the currency you deal in will not go as far tomorrow as it did today. Purchasing power means how much your money can buy, which is simply ‘buying power’.
You lose purchasing power when prices go up and gain purchasing power when prices go down. But we can’t talk about purchasing power without also delving into inflation, which changes the value of a currency over time.
Inflation changes the value of a currency over time
In most economies, what a currency buys today isn’t what it bought 10 years ago. If your salary remains the same but prices rise because of inflation, though, your purchasing power will decrease and you won’t be able to afford to buy as much as you once did.
Purchasing power doesn’t just relate to how much you can buy with your money. It also affects stock prices, as well as general economic health. That’s because if inflation causes purchasing power to decrease significantly, and the cost of living goes up, that will lead to more cash-strapped consumers.
Letting the currency fall would push up already record high inflation, but fighting back against multi-year lows for currencies worldwide would require more rapid rate hikes, which could add to the misery for an global economy already facing a possible recession.
Depreciation of currency exchange rate raises inflation
Studies frequently cited by central banks worldwide suggest that a 1 per cent depreciation of the exchange rate raises inflation by 0.1 per cent over one year and by up to 0.25 per cent over three years.
Analysts say that until the economic outlook improves the currencies globally will remain in the doldrums. Even if central banks hike rates, the US is hiking by more, luring cash into the top economy. However, analysts also reckon a more aggressive stance is unlikely given the waning growth outlook.
One favourable factor for currencies that are crashing is that shorting them is already a popular trade in currency markets right now and bearish positioning is approaching historical levels. That might prevent the already declining currency from falling sharply, some market analysts opine.
How rate hikes factor into currencies crashing
The US dollar exchange rate plays an integral role in inflation in several economies given its acceptance as a global peg for currencies worldwide. While the result is usually an appreciation of the US dollar, the resultant effect on currencies elsewhere isn’t as favourable for economies. Here’s why.
When inflation is high, goods become more expensive. Goods from a nation with high inflation are less competitive compared to a country with lower inflation – where things are cheaper. Demand falls as the goods become less attractive. As a result, the value of a currency decreases.
While a strong dollar could even help bring down inflation in the US, which has been running at its fastest pace in four decades, economists say the impact would be relatively small, but still positive. But a strong dollar has broad implications for the global economy, devaluing currencies in other countries.
How rate hikes factor into global economic recession
When US interest rates are low, global investors tend to invest more in emerging markets, or the economies of nations that are transitioning into developed economies. But when rates start to rise in the US and the dollar climbs, money starts to flow out of those countries.
Some developing nations are equipped to handle this, since they have more reserves or their exports are priced in dollars and have been rising in value, but other countries could struggle. Sri Lanka’s economy, for example, faced a mountain of debt and not enough US dollars to pay for imports of essential goods.
Countries that borrow heavily in dollars could suffer because it becomes harder to make repayments as the dollar rises and their currencies depreciate. That means the amount of dollars they need to get their hands on to make repayments goes up.
The British pound touched a record low on Monday, and China, which tightly controls its currency, fixed the renminbi at its lowest level in two years while taking steps to manage its decline.
The strong dollar is pushing up the price of imported food, fuel and medicine in Nigeria and Somalia, while nudging debt-ridden Argentina, Egypt and Kenya closer to default and threatening to discourage foreign investment in emerging markets like India and South Korea.
Where does the dollar, currencies go from here?
Currency markets are extremely hard to predict, so it’s difficult to say whether the dollar will continue to climb or fall in the coming months. The dollar could drop if the Russia-Ukraine conflict ceased, analysts evaluate, relieving pressure on European economies and pushing up their currencies.
If inflation stays stubbornly high, as it seems to be currently, the US has to keep raising interest rates more than expected, the dollar could keep rising. It’s a very uncertain environment, and the exchange rate probably is going to be hard to predict.
