Inflation may be an unavoidable economic impact on life, but is starting to make a lot of people nervous. Most market participants believe that inflation is primed for rapid growth as trillions of dollars have been pumped by the Federal Reserve and layered that with sub-zero rates.

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But now the question arises whether inflation will be modest, a managed wave or a dramatic flood that will roil markets. There are also some who aren’t overly concerned that inflation will spiral out of control, especially since the economy has plenty of post-pandemic ground to make up.

The stance of major central banks

Since the start of the pandemic most major central banks have cut rates and at the same introduced massive stimulus packages. Central banks printed money and were there to support the economy, but what it also led to was higher inflation.

Major central banks maintained a dovish stance and kept rates low with a primary reason to support growth and not be much concerned about price rise.

Be it the Federal Reserve, ECB, Bank of England, Bank of Japan or any other central bank across the world, all more or less had a similar tone and said that ‘We will do whatever is needed’ to support the economy.

Fed was in the forefront keeping rates low and that led to broad weakness in the dollar against its major crosses.

Fed turns hawkish

In the last year, most economies have witnessed a ‘V’ shape recovery with the support provided by respective central banks. There are some major central banks that continue to hold a dovish stance and at the same time, there are a few that also have started to turn hawkish.

The Fed again seems to be leading the others to slowly and steadily move towards tightening. US economy is booming and driving inflation higher around the world and pushing up the US dollar.

These events are pressing some central banks to increase interest rates, despite still-high levels of COVID-19 infections and incomplete economic recoveries in their own countries.

Not only did the Fed begin talks on eventually reducing the pace of its $120 billion monthly asset purchase program, but the economic projections of US central bank officials revealed that most now expect a two-notch interest rate rise in 2023, a year earlier than what was forecasted three months ago.

It looks like the beginning of the transition phase from really accommodative monetary policy to what is going to be less accommodative monetary policy.

How will currencies react?

Last year was a crowded trade towards going short on the dollar and now that seems to be unwinding since the Fed turned hawkish.

On the other hand, emerging market currencies fell against the US dollar after the Fed policy statement. Going ahead we expect that comments from other Fed governors will also be important to watch.

More hawkish statements from the Fed members are likely to extend gains for the dollar. Market participants will focus on the movement in US bond markets and their effect on yields as well as upcoming economic data releases.

Outlook for dollar

For the next couple of months, we expect that continued growth in the US, higher inflation prospects and hawkish comments from Fed members are likely to extend gains for the greenback.

We expect the dollar index would continue to get support at lower levels also if economic data releases show an all-around recovery in the US.

Technically, the dollar index faces resistance at 92.50 and a sustained close above this level could take it higher towards 95.00 and above. On the downside support for the dollar index is placed at 90.70 and 89.50.

— The author, Gaurang Somaiya is Forex and Bullion Analyst at Motilal Oswal Financial Services. Views are personal.

(Edited by : Yashi Gupta)

First Published:Jul 2, 2021 12:09 PM IST