The US has been experiencing high inflation for the last four decades and inflation is rising steadily. The annual rate of inflation from October 2020 to October 2021 was 6.2%. In fact, Consumer Price Index (CPI) rose by 7.5% which was the fastest since February 1982. Inflation growth has been rising since the Covid-19 pandemic hit globally and the Covid-19 recession has led to major behavioural changes.
Introduction and basics
Lockdown and social distancing affected our daily activities and economy around the world. Experts believe that Covid-19 has impacted the supply chain which created a supply and demand imbalance driving higher inflation and the rise of the Consumer Price Index. In the report below we try to analyse the main key factors that led to this exponential rise of inflation in the US starting from 2020 up to now with consequences to the value drop of the United State Dollar (“US$” and “USD”).
We will highlight how variables such as national debt, demands of goods and government expenditure affected the economic equilibrium causing major currency fluctuation focusing on the impact of the budget deficit and national debt.
Observation and analysis
As briefly introduced, a factor that heavily affected the inflation in the US during recent fiscal years with obvious consequences to the fluctuation of the local currency is the historical highest record of the US debt related to the budget deficit – broken down as: factor 1 increase in national debt, factor 2 deficit in budget due to government’ spending.
In fact in the last few years (closing at September 30, 2020) the US had a US$ 3.129 trillion budget shortfall, more than twice the amount of US$1.4 trillion deficit during the financial crisis of 2008 as shown in the chart here below, with the Senate Democrats further approving in mid-2021 a budget resolution, lining up an additional US$ 3.5 trillion spending bill, just after approving a bipartisan US$ 1.2 trillion infrastructures’ plan.
By following step by step the key points stated above we can see as the federal budget deficit will increase the national inflation despite the impression of a strong performing economy.
The budget deficit as clarified above is a result of further government spending in different industries which can be projected as an injection of capital flow in the local economy, this, in a performing economy, results in an increase of consumer spending link to a high consumers confidence which lead to an increase in the demand of goods with a consequence in the rising prices of goods and services. When more spending increases, wages are steady or rising and unemployment is relatively low, inflation is likely to rise.
With the further US$ 3.129 trillion budget shortfall in 2020 the national amount of debt is expected to keep growing. Therefore, with the government borrowing more money will be linked to an increase of issuing of treasury securities which will compete against securities issued by the private sector. As the rate offered on treasury securities will keep increasing, business operating in the US will be perceived as riskier and will make saving more appealing, necessitating an increase in the yield on newly issued bonds. This, in turn, will require business to increase the prices of goods and services to meet the increased cost of their debt service obligation. Over time, this will cause people to pay more for goods and services, as a parallel effect of the increase of government spending resulting in another factor of a raising inflation.
As anticipated in the preface of this section, the above causes to inflation will have an effect on the value of the local currency. In economic, in fact, inflation directly affect the time value of money – conceptualization for which, in a very brief and summarized version of the formula, a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.
The usual direct effect that inflation has on a local currency is to devaluate it since inflation can be equated with a decrease in a money's buying power, resulting in countries experiencing high inflation leaning to see their currencies weakening in relation to other currencies.
As a result since 2020 the US$ volatility increased and bank experts predict this will continue to be the case in 2022 as it has been in 2021. Furthermore, with the uncertainty from the coronavirus pandemic, a tumbling US economy and an increase in US$ money supply will keep the US$ weaker than other currencies in the close upcoming years.
In the graph below we can see the direct correlation with the devaluation of the US$ in relation to the increase in the yield on bonds (in particular foreigner holdings) linked to the soaring federal debt as touched and explained in the points described above.
Conclusion and Opinion
Summarizing, we can clearly observe how the economic and reserve factors pushed inflation to destabilize the local currency and causing major fluctuation of the same.
We have mentioned how supply chain disruption has caused the price of goods to increase which impacted inflation and we observed how the budget deficit, with mass spending, highly contributed to further deteriorate the economic equilibrium to an even further rise of the inflation.
The usual direct effect that inflation has on a local currency is to devaluate it, since inflation can be equated with a decrease in a money's buying power, resulting in countries experiencing high inflation leaning to see their currencies weakening in relation to other currencies. As a consequences of the high inflation connected to the time value of money principle, the value of the US dollar depreciated with a major drop in 2021. The purchasing power of the dollar to buy a goods decreased and is still decreasing due to the higher commodity price.
In response to this economic situation, since the Covid-19 crisis, Federal Reserve has taken immediate actions, including easing monetary policies. On March 15, 2020, the Federal Reserve decreased the interest rate to range 0% to 0.25% and launches a massive $700 billion quantitative easing program. This program was aimed to boost the spending by lowering the interest the cost of borrowing households or businesses and in short term will boost the economy. However, this program has increased inflation as the Consumer Price Index (CPI) reflected inflation toward the federal fund rate (interest rate).
To conclude, in contrast to spending on consumer goods, spending on services remains below its pre-pandemic peak - as per beginning 2022, and this observation presuppose that due to the recent surge in consumer goods inflation, we might expect a stop on a possible persistent raising inflation in this sector going forward.
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https://www.brookings.edu/research/fed-response-tocovid19/#:~:text=Easing%20Monetary %20Policy, of%200%25%20to%200.25%25