The headline may mislead investors, but there is a logic behind it. The logical interpretation is that when inflation rises, the value of a currency declines. But, and this is a big but, this applies only if inflation exceeds the central bank’s target.
Most central banks adopted inflation targeting for a while now. Effectively, it means that the central bank considers a certain inflation level as appropriate for economic growth. To fight deflation, the worse of all things, central banks are willing to let inflation run below but close to 2%.
The Fed in the United States does not target a certain inflation level explicitly. Instead, it has a dual mandate – one that focuses on both job creation and price stability (a.k.a. inflation).
Why Did the USD Decline After Upbeat Inflation Data?
This week’s Consumer Price Index (CPI) in the United States revealed much higher inflation than expected. The MoM headline showed inflation doubling, while the more important metric, the Core CPI, tripling! Core inflation or the Core CPI refers to data that excludes energy prices, such as oil and transportation, considered too volatile.
Despite the increased inflation, it only jumped from 0.2 to 0.6 on the Core data. In other words, way below the Fed’s 2% target. Effectively, it means that while it remains below the target, the Fed accomplishes the price stability side of its mandate.
Therefore, the market simply ignored the CPI data. Normally, with inflation tripling as it was the case with the Core CPI, the USD would appreciate. Why?
On such news, the expectations grow that the Fed will intervene and raise the rates. Or, at least, they will change to tone on the next FOMC Statement, signaling tightening conditions to come.
However, that would be the case only if inflation would be above 1% and rising. Moreover, in times of crisis, like the one we live nowadays, the Fed may be willing to accept even higher inflation, as a sign that money velocity increases, businesses, and households spend, and the overall sentiment improves. Letting inflation overshoot is one option the Fed is likely to use moving forward.
Coming back to this article’s title, the USD declined because inflation, even if tripling on a monthly basis, is still far below the Fed’s target. The more it comes closer to it, the less the USD will decline, as the Fed will step up and alter the monetary policy.