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Theory without practice is dead. Purchasing power parity and other theoretical developments, for the most part, look tritely stupid when predicting exchange rates. That is, in real life. However, life often makes us remember that they exist. So one version of the PPP says that a stronger monetary unit has a greater purchasing power. At the same time, high inflation undermines this ability. For the past two months, inflation in the euro area is higher than in the US, and EURUSD is heading down head over heels. Why not an argument in favor of theoretical constructions?
Larger fiscal stimulus during the pandemic in the US than in the eurozone led to the assumption that consumer prices would also rise faster in North America than in Europe. At first it was, but the energy crisis changed the rules of the game a bit. Gas in the eurozone skyrocketed, pushing inflation in the currency bloc countries above 10%. The states are falling behind. But that's not what matters. Even Bloomberg analysts expect that at the end of next year, there will be a slowdown in the European CPI to 5%, and the American one to 3%.
Inflation dynamics in the eurozone and the USA
By itself, inflation in the process of exchange rate formation on Forex practically means nothing. Much more important is the reaction to it from the side of central banks. If the federal funds rate is expected to rise to 5% in 2023 and the European Central Bank deposit rate may fall short of 3%, what is the real return on assets? In the US, it is significantly higher than in Germany, the leading country of the bloc. The transfer of capital from the eurozone to America is the foundation on which the EURUSD downward trend is based.
The rest is details. Like, for example, the decision of the British Chancellor of the Exchequer Kwasi Kwarteng to abandon the idea of tax cuts for the wealthiest citizens of the United Kingdom. This circumstance further undermined the confidence in the new government of the country and forced the pound to retreat. And along with it, other European currencies fell into disgrace, including the euro. Because everything in the world is interconnected. And shocks from Great Britain involuntarily spread to the financial markets of Continental Europe.
In fact, the euro has already taken into account the factor of excessively high gas prices, and until blue fuel rises even higher, EURUSD will draw consolidation. Unless, of course, the pace of tightening of the ECB's monetary policy remains the same as that of the Federal Reserve. At 75 bps at every meeting of the Governing Council. In order to launch a serious correction, you need to raise rates even more aggressively. With the prospect of bringing them up to 5%. This is the only way to suppress higher inflation than in the US.
Technically, a 1-2-3 correction pattern was formed on the EURUSD 4-hour chart. A breakthrough of support near point 2 and the pivot level at 0.9730 is a reason to open short positions in the euro against the US dollar. The targets for short positions are 0.9635, 0.9600 and 0.9550.
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