uploads///Inflation and US Dollar

How Inflation Impacts the Exchange Rate

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Jan. 23 2017, Published 4:27 p.m. ET

Macroeconomic indicators to increase expectation of inflation

Central banks across the globe manage their key interest rates by keeping an eye on various economic indicators like inflation, economic growth, and the condition of the labor market. Banks then decrease key interest rates to stimulate lending activity, and vice versa, considering other macroeconomic indicators.

Consider the following underlying macroeconomic indicators of inflation in 4Q16:

  • Gasoline and transportation services underlying the US CPI (consumer price index) in December gained 0.2% at 243.03, as compared to the previous month.
  • Consumer prices rose 2.1% YoY (year-over-year) in December.
  • Inflation accelerated for the fifth consecutive time in December 2016 with the surge in energy prices.
  • Annual core inflation, excluding food and energy, gained 2.2%.
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Dollar rises as inflation inches up

Inflation expectation is high now that several macroeconomic indicators showed a surge in prices and spending. Growth in inflation, which is expected to balance the interest rate hike, is meanwhile helping the dollar on its path to recovery.

The dollar gained ~4% in the past two months. Inflation is rising but is still under the Fed’s target of 2%. The probability of another rate hike soon is high until the inflation is under target and business sentiment turns positive. Still, it’s not quite clear how markets will react to the lift in interest rates as markets recover.

The PowerShares DB US Dollar Bullish ETF (UUP), which tracks the performance of the US dollar, fell 0.34% on January 20, while the WisdomTree Bloomberg US Dollar Bullish Fund (USDU) dropped 0.22%. Sectors such as consumer staples and utilities are expected to perform better as the US dollar rises as well. Specifically, the Consumer Staples Select Sect SPDR (XLP) rose 0.65 % on January 20. Major XLP holdings include Procter & Gamble (PG), Coca-Cola (KO), Philip Morris International (PM), and PepsiCo (PEP), which gained 3.25%, 0.44%, 0.77%, and 0.86%, respectively.

However, as the dollar gains strength, it affects other economies and currencies globally. We’ll look at the impact of the rising dollar on the euro in the next part of this series.

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