How Will Inflation Affect the US Dollar?

It is getting harder and harder to find employees to fill positions in jobs ranging from computer programming to entry level spots. We can expect to see wage inflation take hold in the American economy. The question for Forex traders is how will inflation affect the US dollar? Bloomberg discusses the interest rate dilemma facing the US Federal Reserve as the economy runs short of workers.

Seven years into the economic expansion, the U.S. is showing some signs of running short of people who want jobs and are qualified to fill existing openings. The shortfall, which has been evident for some time for highly skilled workers such as computer software developers, is starting to spread to those with lesser talents as unemployment falls further.

“We are now close to eliminating the slack that has weighed on the labor market since the recession,” Federal Reserve Chair Janet Yellen said in a June 6 speech in Philadelphia.

At an almost nine-year low of 4.7 percent in May, the jobless rate was around the level that most Fed policy makers reckoned was equivalent to full employment when they released their last economic estimates in March.

One of the tasks of the US Federal Reserve is to deal with or ideally prevent excessive inflation. Raising interest rates is a common tool used by the Fed for this purpose. However, the Fed has been hesitant to raise rates as the global economy suffers and US growth tapers off. Thus inflation may take hold as the Fed waits. How will inflation affect the US dollar?

Inflation and Exchange Rates

Inflation Calculator looks at the effect of inflation on exchange rates.

Exchanges rates and inflation are closely related and can influence one another. A weak Canadian dollar helps businesses and industries that rely on exports for a large portion of their income. As the currency drops, the cost to their foreign consumers falls and they are likely to buy more. This in turn translates to higher profits, production, employment, and output. When output goes up, inflation goes up. In theory, the higher demand for Canadian goods will lead to higher demand for the loonie, which will bring the exchange rate back into equilibrium.

More intervention is needed in order for the inflation rate to have an impact on the exchange rate. When inflation is high, central bankers will often increase interest rates in order to slow the economy down, and bring inflation back into an acceptable range. Whenever interest rates go up, it becomes more attractive for foreign investors to move funds into the country for deposit and to buy bonds.

Thus the end result of inflation is to drive up the value of a currency. How inflation will affect the US dollar is to drive it up as the Fed increases interest rates. To the extent that the Fed does not act it might drive the dollar downward. In either direction inflation or the threat of inflation drives the US dollar.