30th September 2021

• We think that a return to a regime of higher and less stable inflation in many major economies would result in a rise in exchange rate volatility and, over time, the depreciation of the currencies of those countries which experience higher inflation.
• 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. Indeed, on a long enough period, this effect often dominates other factors affecting exchange rates, such as relative productivity and terms of trade.
  
  
• A key feature of the past two decades has been low and stable inflation across most developed markets (DM). Aside from Japan and Switzerland, there have not been big inflation gaps between major economies.
  
  
• By contrast, the period of high inflation in the 1970s and 80s saw significant variation in inflation outcomes. This had three major impacts on exchange rates: countries with high inflation generally saw their nominal exchange rates weaken over the period as a whole; when policymakers responded with tighter policy (most notably Fed Chair Volcker’s efforts in the early 1980s) it led to significant, though temporary, currency appreciation; and exchange rate volatility for the major currencies was considerably higher than it has been in the more recent era of low and stable inflation.
  
  
• In emerging markets (EM), inflation has also been trending lower across most major economies over the past couple of decades. Before the pandemic, some economies in Asia and Central Europe were arguably close to a similar low and stable inflation regime as developed economies. But inflation has been higher and more volatile in many other major EM economies, although less so than in the past, and their exchange rates have generally been more volatile as well.
  
  
• We think that inflation will remain persistently higher in several major economies, including the US, than in the recent past. We anticipate that this would have two key effects on currency markets.
• First, the currencies of those economies where inflation remains high would, over time, depreciate. Among developed economies, we think the US, as well as the UK, Canada, and Australia, are more at risk of sustained higher inflation. This suggests to us that their currencies will weaken in nominal terms relative to the currencies of many European and Asia economies, where we expect inflation to remain subdued.
  
  
• Among the major emerging markets, we think that, aside from Argentina and Turkey (where inflation has already been in the double digits in recent years), Brazil, Colombia, South Africa, Indonesia, and the Philippines are at risk of a significant pick up in inflation, which would undermine their currencies.
  
  
• Second, exchange rate volatility among the major currencies would increase compared to the past two or three decades. Greater uncertainty around inflation outcomes (and the policy response to them) would probably result in larger swings in currency markets, along the lines of what was common in the period of high inflation in the 1970s and 80s.
  
  
• How precisely our scenario of higher inflation would play out would depend in large part on the response of policymakers in economies with persistent upward pressure on inflation. Our base case is that most policymakers will continue to keep real interest rates low in order to boost economic growth and to reduce high debt levels gradually. But to the extent that some central banks attempt to bring inflation down through tightening policy significantly, that could generate more significant volatility.

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