Inflation and the US dollar

Inflation poses an interesting dilemma for the US dollar. On the one side, inflation erodes the currency's real value, driving it down. However, if the US Federal Reserve Bank raises interest rates to prevent inflation, then real rates continue to rise.

On the other side, if the US Federal Reserve Bank is "behind the curve", then the market assumes it would be raising interest rates to contain incipient inflation that was already prevalent. In this case, the Federal Reserve would be playing "catch-up" with inflation.

In such a scenario, higher short interest rates do not help the currency. In particular, if the Fed is raising interest rates in response to a late cyclical pick-up in inflation while growth is slowing, this could be particularly damaging for the US dollar, a view that is gaining momentum.

There are prospects for very high real rates in the short term associated with a stronger US dollar. However, with the heightened risk of overtightening, the market may start to worry about a more damaging slowdown due to an ultracautious Fed.

The changes in break-even interest rates have been quite large this year and, due to renewed worries about inflation, the question of real interest rates has raised its head. This may help explain why nominal interest rate differentials are no longer such a powerful driver in the foreign exchange markets compared with last year.

In addition, the biggest rise in break-even rates, a good proxy for inflation expectations, has been in the US, despite the US having had the biggest interest rate rises in nominal short rates over the past couple of years.

The market perception of inflation can be very damaging for a currency such as the US dollar. However, does an inflation-fighting Fed want a stronger US dollar? To ascertain the impact of the US dollar on inflation, it is necessary to look at the influence of import prices on CPI inflation.

To help gauge this better there is the import price "impact index" - the openness of the US economy over time multiplied by import price inflation. The openness of the US economy is measured by import penetration, that is imports as a percentage of domestic demand.

This demonstrates how important imports are relative to the domestic economy. Until 2000, import penetration moved up aggressively and, since then, has only drifted higher.

Multiplying the import prices by import penetration results in a measure of the importance of import prices in the inflation process.

As compared to inflation measured by the CPI, inflation should be rising more aggressively than it has been. It shows that, as import inflation has risen, headline inflation has also moved up. However, crucially, the response of headline inflation has been much lower than in the pre-1999 period.

One may argue that this is all to do with the lack of second round effects on the rest of the economy associated with higher oil prices, as a large proportion of the rise in import prices is due to the rising price of oil rather than anything to do with the US dollar.

It is also worth looking at the relationship between an import price impact measure, excluding gasoline, against CPI inflation, excluding energy. This shows that although the "core import price impact index" has risen quite substantially since 2002, its rise has not been passed through into higher core inflation. In fact, there seems to be little or no relationship between the ex-energy measures.

This relationship also suggests that, although some import goods prices are rising, US retailers are loath to push the prices on to consumers. As a result, domestic US margins are being squeezed. However, profitability is high, so it still seems to indicate that US productivity growth is strong domestically and is swamping any influence that import prices may be having.

Of course this may change, but it is less likely to do so because of the value of the US dollar.

The stage is approaching where the Fed may want to increase interest rates due to inflation concerns and not take any chances. If the inflation concerns prove to be real, then this should be negative for the US dollar, bonds and equities.

Even if the concerns are imaginary, this may only be found out after short interest rates have risen by more than the market is currently factoring in. This, in the short term, may help the US dollar as short interest rates are driven up.

Ultimately, however, the belief is that these inflationary concerns will dissipate as the economy cools and it will become clear the Fed has overtightened. The point at which the market starts to price in that rates need to be cut will prove to be the next major down leg for the US dollar.

HSBC Research believes that this is still some months away and, although the US dollar is expected to fall substantially over the next 18 months, the next big fall needs to be preceded by a big change in the interest rate sentiment.