Over the last several years, the United States dollar has gained remarkably in value. This trend is a near mirror image of the Federal Reserve’s tightening monetary policy stance. As inflationary pressures in the U.S. economy emerge, influenced by trade tensions, experts are wrestling with the implications of these developments for future interest rates and inflation expectations.
And the Federal Reserve remains very much in the cautious camp, pretty much still claiming the mantle of the most cautious central bank in the world. This self-imposed restraint has fueled the dollar’s strength, making for a difficult market expectations headwind. Perhaps it is no surprise then that U.S. inflation numbers continue to be relatively calm in the face of persistent worries about inflationary impacts from trade wars.
Most economists and trade analysts would agree that the inflationary shock created by the trade war is transitory. This assumption is fraught with risk and has tremendous price-altering consequences for market participants. The conversation that continues to exist about these inflationary pressures will be important because argumentation about what it means for interest rates moving forward.
While inflation expectations have largely traded sideways since early April, they are increasingly spread to the long end of the curve. Survey-based metrics — such as the University of Michigan’s measure of long-term inflation expectations — show that inflation expectations are deflated, if not dead. The market is pricing in inflation expectations that are closer to 3.5% over the next year. Concurrent with that, it expects interest rates to decrease by over 100 basis points.
“Market expects inflation to reach around 3.5% in the coming year and interest rates to fall by over 100 basis points. Since the beginning of April, expectations have also tended to move sideways – although it should be noted that inflation expectations are continuing to shift further into the future, as inflation is being viewed here in one year’s time, starting from the rolling starting point.” – Commerzbank
Specifically, the policies pursued by the president of the United States have been central in determining these inflationary expectations. Donald Trump’s election ushered in a huge increase in expected inflation. This surge was mostly due to anticipatory expectations that with him in charge, his administration would pursue an alternative inflationary policy strategy. Market participants think this implies that if upside risks to inflation emerge, higher key interest rates will be needed. This impression is a product of recent economic conditions.
Some experts warn about placing too much weight on the belief that today’s inflationary pressures are just transitory.
“Even if the risky assumption that US inflationary pressure triggered by the trade war is temporary proves correct, this assumption is likely to influence market expectations. We are moving away from a Fed that actively responds to inflation expectations towards other central banks that are quicker to cut interest rates than raise them. This is another bad sign for the US dollar.” – Commerzbank
These U.S. tariffs are producing an inflation shock that the economy cannot afford. Like a runaway freight train, this confluence of events is hammering consumer prices and bending market sentiment in an unprecedented direction. Our central bankers have a tough job trying to walk the line between keeping our economy limping along and increased inflationary pressures.
“Central bankers should probably refrain from assessing transitory inflation risks after misjudging the situation during and shortly after the pandemic. It is not at all easy to predict how transitory an inflation shock will ultimately be. The decisive factor is that the US dollar has appreciated enormously in recent years because the Fed has been one of the most cautious central banks.” – Commerzbank
Whatever happens next, all eyes are glued to inflation trends. They’re equally glued to what the Fed is going to do in response. These dynamics will be a critical battlefield in the future story of interest rates. They will have real effects on long-term economic growth in the United States.