Rising US inflation expectations triggered a move lower in the US dollar. What will happen when actual core inflation increases?
Next Friday, the US will release the Core PCE Index monthly data. The acronyms stand for Personal Consumption Expenditure, and it represents the change in the price of goods and services purchased by consumers. Because this is the “core” release, it means that energy and food prices are excluded, as they are considered too volatile.
Investors care about the Core PCE data for at least two reasons. First, the recent inflation data out of the largest economy in the world points to rising prices more than initial estimates. Second, the Core PCE is the Fed’s favoured tool for measuring inflation.
Higher Inflation in the United States – Good or Bad for the Dollar?
Rising inflation translates into a depreciating currency. That is the case with all fiat currencies, but the US dollar has a particular case in the sense that it is the world’s reserve currency.
The Fed took the markets by surprise last Wednesday. The FOMC Minutes revealed that some Fed members are aware of the need to taper asset-purchasing in the near future — in a sign that rising inflation in the United States does not make Fed members indifferent.
When interpreting inflation, one needs to understand the difference between nominal and real rates. Real rates coupled with inflation make up the nominal rate. The problem here is that the current environment has led to the lowest US real rates ever, which means that the inflation premium is a bigger component in the nominal rate.
According to a study by Nordea, a European investment bank showed that the dollar index (DXY) actually gained during periods of high inflation. The study focused on the 1970s, a period characterised by higher inflation in the United States.
The key in interpreting the effect of inflation on the DXY is to make a distinction between inflation expectations and the move in the actual core inflation. It appears that when inflation expectations are on the rise, as they have been recently, the US dollar declines against its peers. However, when the actual core inflation starts printing higher, the US dollar is king, as shown by historical data.
All in all, this Friday, we will have a chance to test this theory. Depending on how the market reacts to the Core PCE data, traders may have an educated guess about what to expect in the last month of the second quarter.