Inflation Expectations and the Impact on FX Market

FX traders will need to carefully prepare for 2021, even though the market’s current stance is that the pandemic will be over and things will get back to normal. Even though that’s the best-case scenario, several other factors could weigh on FX valuations and one of them is inflation. As you prepare for the Christmas Holidays, we would like to talk briefly about the topic and see whether there will be any inflationary pressures next year.

US M2 money supply skyrockets

According to the data released by the US Federal Reserve, the M2 money supply increased by over 20% in 2020, a record figure that had not been seen since the early 1940s. Even during the 2008 financial crisis, the figures could barely pass above 10% and it would be fair to consider the consequences of such development. Experts continue to remain divided on the inflation topic, given there will continue to be both inflationary and deflationary pressures even after the pandemic ends. We could look at the past and figure out what might be the case for 2021.

Inflation to pick up starting with Q2 2021?

If we think about it, inflation represents a larger amount of money chasing a finite number of goods and services. Now that governments around the world had flooded the markets with liquidity by increasing budget deficits, it would be fair to assume that there is a lot of money into the economy, but velocity continues to remain low.

The COVID-19 pandemic is expected to persist well into Q1 2021 and as a result, people and businesses will be reluctant to spend. However, once things get back to normal, the combination of strong purchasing power and limited supply (as companies cut down production) can lead to an inflation spike starting with the second quarter next year.

Short-term spike or long-term change?

We should give credit to the deflationists also in the longer run, as the financial system had not changed at all and the money that’s been created is actually loaned into existence, which will need to be paid back later on.

Could the inflationary pressure only be temporary? In case governments will step back on stimulus, that’s very likely. However, it seems like the opposite will happen and in the next several years we could witness a reversal of a long-term secular trend in inflation. Keep in mind that we’re unable to predict the future, but we can only try to figure out the probabilities based on different variables. Unprecedented government spending will have consequences and one of them could be inflation in the shorter run.

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