BofA Says Low-Inflation Era Over With More Dollar Strength Ahead

(Bloomberg) — Sticky price pressures will make it harder for central banks to stay committed to current inflation targets, a narrative that will drive currency markets from here on, Bank of America Corp.’s strategists say.

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Strong labor and inflation reports are firming up the belief for some that higher price pressures are here to stay, and that central banks’ credibility is at stake in the attempt to tame them to expected goals. With inflation and developed currency markets positively correlated, that poses a risk of the dollar strengthening more, according to Athanasios Vamvakidis, BofA’s head of G-10 FX strategy.

“Which central banks will stick to their inflation target and which will not will determine FX ahead,” he wrote in a note, predicting a “blinking game.” Officials committed to do whatever it takes to meet their goal will see their currencies strengthen the most, he said, adding that the era of low inflation is over.

While anchoring inflation at a targeted level has been a tenet of monetary policy since the 1990s, the 2% goal adopted by major central banks including the Federal Reserve has been the subject of renewed scrutiny as prices soar.

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Fed officials including Philip Jefferson and Thomas Barkin pushed back against increasing the target in recent weeks. Others suggest central banks pursue a slower return to the same 2% goal. There are concerns across the Atlantic too. Howard Davies, chairman of NatWest Group Plc and a founding member of the Bank of England’s Monetary Policy Committee, said the UK risks “unpleasant” results if it tries to bring inflation down to its target too quickly.

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For BofA’s Vamvakidis, central banks’ reliance on very loose monetary policies before the current inflation spike could exacerbate the economic pain required to return to 2% targets. The low-inflation era is over, he said.

“Any central bank that seems more willing to do the easy part of its job than the difficult part, more willing to be popular than unpopular, offering plenty of punch early in the party, but being unwilling to remove the punch bowl as people are getting drunk, will lose credibility and see its currency weaken.”

Historically, it takes time to bring down inflation once it’s risen so much, and monetary policy isn’t tight enough yet, while labor markets are very stretched and fiscal policy is too loose, he said.

Vamvakidis’s bullish dollar forecasts played out to some extent last year, though the US currency’s slump in the final months of 2022 caught his calls off-guard. His outlook on the persistence of inflation has since hardened: in September, he said central banks could avoid a hard landing, but now his team see a soft landing as the least likely option.

“It is too early to have a view of which central bank will stick to its target and which will blink,” said Vamvakidis, who expects the debate to become more relevant in the second half of the year.

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