Like Godzilla awakened from hibernation to terrorize the world, inflation has sprung to life. At least two generations (Millenials and Gen Z) have never experienced a period of high inflation during their lifetimes. Dramatic increases in gas, food, and rent prices are battering consumers. And they are rightfully asking: “What’s happening and why?”

History of Inflation

The last time inflation reared its head was in the 1970s. After years of increasing prices, the then Fed Chair, Paul Volcker, implemented harsh monetary policy (including 20% interest rates), finally extinguishing inflation in the early 1980s.

These policies caused a deep recession and widespread consumer pain before a sustainable low-inflation recovery occurred. Remember 18% mortgages? Those buying houses in the 1970s and early 80s will acutely remember such times. However, since recovering from the post-Volcker era, the U.S. has enjoyed relatively low inflation for decades—until now.

Evidence of Inflation Starting in 2021

When the first signs of inflation began to show, they were attributed to a global economy recovering from the pandemic. Renewed consumer demand for goods and services faced strained supply chains, causing huge spikes in the equilibrium between supply and demand. However, economists, including those at the Fed, saw this as transitory inflation. Once supply chains bounced back, inflation would subside.

The outbreak of war in Ukraine and the resulting disruption of the world’s energy and food supply threw gasoline on the fire. Inflationary pressures did not subside, and in March 2022, the Fed belatedly began to address the problem through monetary policy by raising interest rates.

Economic theory suggests that rising interest rates will slow demand for goods and services, leading to the end of upward price pressure. That’s the theory. Will it work? What about the collateral damage? The future of inflation is unclear.

The Attempt to Curb Inflation

Some economists express concern that the Fed’s actions only address part of the problem, meaning that the Fed can slow demand by raising the cost of credit, but it cannot affect supply issues. For example, high gas prices are driven by global supply issues, and the Fed can’t do anything about that. Likewise, they can’t print wheat to combat the shortage caused by Ukraine’s inability to export grain. Additionally, previous policy actions, including tax cuts and stimulus checks meant to jump-start the post-COVID economy, are now contributing factors to inflation that are out of the Fed’s control. 

Finally, and perhaps most importantly, the Fed has limited tools to curb inflation. The history of inflation shows that monetary policy can have unintended consequences.

The Fed raises interest rates to try and curb demand, but higher interest means a stronger dollar.

A stronger dollar means cheaper goods from overseas (imports). Paradoxically, we may see a rise in global inflation due to higher interest rates in the U.S., so what’s next? 

Fed Chair Powell has made it clear that he will continue to raise rates until he is confident that inflation has been contained. In his words, “Restoring price stability will likely require maintaining a restrictive policy stance [Fed-speak for high interest rates] for some time. The historical record cautions strongly against prematurely loosening policy. We must keep at it until the job is done.” He also warned that necessary monetary policy actions “will bring some pain to households and businesses.” History suggests that a recession is unavoidable. The hope is it will not be a deep recession that lasts for a sustained period.

Implications for the Global Economy

The dollar has risen dramatically in response to the Fed’s action. Since March, the DXY has risen 14% against a basket of major currencies. The strong dollar has affected virtually every corner of the world. Dollar strength has made servicing dollar-denominated debt (over $15 trillion globally) more expensive. Emerging economies are being hit the hardest by the double-whammy of the high dollar and higher interest rates. 

Although most countries have followed the Fed’s monetary policy lead in raising interest rates, the U.S. has maintained an interest rate advantage against most currencies, keeping the dollar uptrend intact. Japan and China have bucked the global trend of raising interest rates, citing low inflation in their economies. The Japanese yen has been the weakest major currency against the dollar. The history of inflation suggests that the yen will stay weak as long as the Bank of Japan maintains low interest rates.

The strong dollar has lowered the costs of imported goods into the U.S., but it has led to more expensive U.S.-made goods for the rest of the world. U.S. expatriates living abroad and paid in dollars benefit from the strong dollar giving them more buying power. Conversely, people living in the U.S. and paid in foreign currency have seen their cost of living increase with decreased buying power. It is important to note that 40% of the revenue for S&P 500 companies comes from international sales, so the strength of the dollar is hurting profits as U.S. goods become more expensive.

Planning Ahead

We don’t know for sure if the dollar will continue to appreciate. But history tells us that currency trends persist for long periods, so the dollar’s run may be far from over. If your company is experiencing problems with the strong dollar, it makes sense to consider a forex hedging strategy.

Inevitably, the dollar will reverse course. Looking to history (and specifically the history of inflation) as a guide, the move is likely to be substantial when the dollar does drop. The weak dollar will create a whole new set of problems for businesses with cross-currency exposure, so the key is to prepare for the future with a hedging plan to mitigate FX risk.