How does the rise of inflation impact euro/dollar exchange rate?

Since 2017 and especially during the massive print in 2020-21, people have been theorizing that heavy printing by the US Central Bank will lead to inflation. As such, Euro has exerted pressure on the USD, and we believe that it is ready to make gains in the short term. In the long term, however, things become a bit complicated.

The short-term view: Inflationary pressures on the dollar

By the end of 2020, around 22% of all circulating USD had been printed in that year. With the government struggling to save the economy in the wake of the pandemic, inflationary pressures began to assert themselves.

However, there were only minor rises in inflation during 2020, going from 0.33% in April to 1.36% by December. It was in 2021 that the USD began to unravel. Inflation rates climbed to 2.62% in March, 4.16% in April, 4.99% in May, and 5.39% in June. A rise in prices automatically leads to the devaluation of the home currency as it loses its purchasing power.

In the Euro area, the inflation for the month of June was 1.9%. With the expected inflation rates much lower for the Euro area than the US, we expect it to make gains against the dollar for the remainder of 2021.

The 5-year expected inflation rate (orange) seems to impact the strength of the USD directly.

With a similar sentiment in mind, Goldman Sachs upped its forecast for the Euro in April. Citing that vaccinations were taking place much faster in Europe, the renowned investment bank forecasted a three-month target of 1.25, with a twelve-month target of 1.28. The company also expected the pan-European Stoxx 600 index to return 10% instead of 6% for the S&P 500.

Keeping all these factors in mind, it seems likely that the Euro will make substantial gains against the USD in the next few months. Goldman’s price target seems reasonably adequate, and we expect the EUR/USD exchange rate to be hovering between 1.25-1.30 this time next year.

The long-term view: Stability beyond 2023

Although long-term forecasts are complicated due to COVID-19, we have a few critical indications of when the USD could bounce back.

The FED is expected to keep interests low at least until the end of 2022 to combat the effects of the pandemic. As such, the median inflation for 2022 is expected to be 4.8%. However, most analysts expect a sharp rise in interest rates beginning in 2023, which will have two significant effects. First, it will help curtail inflation. Second, it will make the USD more appealing as a currency.

However, it may be difficult for the FED to stop its asset purchases , all the more so when it comes to interest rate increase - even if inflation rises. In 2018, the market has dropped sharply when FED cut its purchases and we are in doubt how far the FED will go. In such case, nobody knows the impacts - but we can estimate an increase of TIPS bond and precious metals such as gold & silver that can provide a protection against inflation.

In June, Europe overtook the USA in vaccination rates. This has led to a better economic forecast for Europe, which should subside in the long run.

This is when we expect the USD to recover against the Euro. By this time, vaccinations should be widespread on both continents. As such, the economic advantage allowed by fewer restrictions in the EU should evaporate, causing the USD to bounce back.

However, it will take time for the changes to take effect. According to most predictions, the EUR/USD rate will stay between 1.20-1.27 in 2023. This is because inflation usually lags the changes in monetary policy by a few months. We saw this recently, when inflation rates rose in 2021, even though the seeds for inflation had been sown in 2020 by the FED’s excessive printing. The rate is expected to fall in Q1 2024, with analysts predicting a range between 1.11 to 1.22 for 2024. 

Conclusion

It is difficult to make predictions beyond 2024, as it is almost impossible to know the economic climate. However, according to nearly all available data and analyst predictions, the EUR/USD exchange rate is expected to rise in the next year or so. 

It is expected to stabilize around 1.15 - 1.25 in mid-2022 and stay around that level towards the end of 2023. Beyond 2023, we expect the exchange rate to fall to around 1.05 -1.15. This makes holding Euros a viable investment opportunity short-term, with the USD being the preferable option for more extended periods. 

However, there are some significant factors that may impact such as the actual inflation rates, interest rate changes and the ability of the European union to keep all countries under the same umbrella.