How transitory inflation became permanent

How transitory inflation became permanent

20 October 2021 from Anna Svahn

When the Federal Reserve previously claimed that the inflation we have seen in recent months will be transitory, many macroeconomists and investors have shaken their heads. It was only recently that the Fed came out with new information: High inflation is here to stay. But what really made them change, and how is it possible, with the transparency that the Fed has, not to see how inevitably high inflation will be in the coming time after more than a decade of money pressure?

When the Fed previously claimed that inflation is transient, they have done so with the belief that they will be able to combat rising consumer prices with higher interest rates while phasing out bond support purchases and eventually even reducing the balance sheet. In any case, that was the plan until new disappointing job figures came out.

In September, it was estimated that 500,000 new jobs would be filled. High inflation means in theory that there is a lot of money in circulation looking for places to be. It also goes hand in hand with companies being able to employ more people, which leads to lower unemployment. Inflation could thus be a sign of an overheated economy, but what we have seen now is something completely different.

Instead of the estimated 500,000 new jobs, it did not even turn out to be half as many new jobs. Instead, the figure was 194,000 new jobs. For Powell, the figures came as a surprise, as the Fed had expected the labor market to keep up with inflation. That is also why the tone has changed from the Federal Reserve in terms of inflation. They are no longer so sure that they can raise interest rates to fight inflation because it would also have consequences for the labor market.

The life cycle of a fiat currency

The future of the USD is threatened. Despite the fact that the US dollar is the world's reserve currency, the coming years look worried about the currency. Several things come into play here, but to understand how this can happen over and over again, you first need to understand what a life cycle typically looks like for a fiat currency, and then try to identify where in the cycle the US dollar is.

First of all - no fiat currency is created with the belief that it will be devalued and eventually become virtually useless. The intention is always to create a strong currency that will be able to function for a long period to come. So how come it - then - in reality - never happens?

The problem with fiat currencies is that they are backed by confidence in the government and the central bank. As long as its users think it's worth something - so is it. This means that there is relatively free play for the issuer of the currency, to increase or decrease the amount of money, depending on what the purpose is or what the government needs.

The average life of a fiat currency is about 35 years. During that time, issuers of currencies have thus in principle always managed to devalue the currency before they realize that it is time to start again from the beginning.

Step 1: Promises and optimism

When creating a fiat currency, the focus is on the promises to stick to the state budget and repay loans. Politicians and central bankers promise not to print more money than absolutely necessary, and only in emergencies.

Step 2: Growth focus

The first phase of a fiat currency's life cycle is short-lived. Very soon, politicians are starting to focus on growth rather than repaying loans. You can do that later. Restrictions set in the first phase are being phased out, and growth will be the single most important factor for the currency. This is leading to the devaluation of the currency, and people need to work harder to maintain their previous standard of living.

Step 3: Asset inflation and artificial growth

The money that is printed initially goes into assets such as the stock market and real estate. Growth is slowing somewhat, which is leading to central banks pushing more and more money to create artificial growth while keeping interest rates low. In the third phase, individuals and companies tend to borrow a lot of money, as asset inflation and low interest rates make it feel like they have more money than they have.

Step 4: Less equality

In the fourth step, the money has been concentrated in a few people. Inequality is greater than before, and inflation is beginning to be seen in consumer prices. For those who are not preparing for an impending currency collapse, the consequences will be devastating.

Step 5: Hyperinflation

In the last step, consumer prices rise sharply as a result of many years of stimulus. The currency eventually becomes useless, and the financial system has to restart.

Outlook for USD

The US dollar is at the end of stage 4. After more than a decade of low interest rates and strong stimuli, it is finally visible in consumer prices at the same time as asset prices are fraught with inflationary unrest. 

Initially, the dollar will look strong, as demand for the USD initially rises when financial assets are sold. After that, there will be a flight of dollars, when countries that have a lot of dollars in their foreign exchange reserves have lost faith in the global reserve currency and are looking for alternatives instead. We have already been able to see that shift happen, since the US dollar in global foreign exchange reserves went from accounting for over 75 percent, to today only accounting for about 60 percent.

Important legal information

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This information is in the sole responsibility of the guest author and does not necessarily represent the opinion of Bank Vontobel Europe AG or any other company of the Vontobel Group. The further development of the index or a company as well as its share price depends on a large number of company-, group- and sector-specific as well as economic factors. When forming his investment decision, each investor must take into account the risk of price losses. Please note that investing in these products will not generate ongoing income.

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30/11/2022 22:01:31


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