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Era of higher inflation would cause major currency volatility, economist says

A currency dealer monitors exchange rates in a trading room at KEB Hana Bank in Seoul on June 21, 2021.

JUNG YEON-JE | AFP via Getty Images

Markets have been gripped in recent weeks by the debate as to whether higher inflation is here to stay, and analysts have suggested the outcome could have significant repercussions for currency markets.

The 10-year U.S. Treasury yield hit a recent high of 1.56% last week as key inflation data showed consumer prices spiking to multi-year highs in the U.S. and the euro zone.

While consensus among central bank policymakers remains that higher inflation is transitory, the result of a confluence of surging energy prices and global supply problems, investors have begun to seek protection, with major stock markets snapping multi-month winning streaks in September.

The return of a regime of higher and less stable inflation across major economies would cause a spike in exchange rate volatility, and ultimately the depreciation of currencies in countries experiencing the highest inflation prints, according to Jonas Goltermann, senior markets economist at Capital Economics.

"Although the near-term relationship between inflation differentials and exchange rates is weak, over longer time horizons countries with relatively high inflation tend to experience depreciation of their nominal exchange rates," Goltermann highlighted in a research note last week.

"Indeed, on a long enough period, this effect often dominates other factors affecting exchange rates, such as relative productivity and terms of trade."

The last two decades have been marked by low and stable inflation in many developed markets, in contrast to a period of high inflation in the 1970s and 80s in which a greater disparity occurred across geographies.

Goltermann noted that in general, nominal exchange rates weakened over that period in countries with higher inflation, but when central banks tightened pol...

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