High Inflation Could Pressure the Fed and Help the Dollar

Source: Daily FX

In order to keep up with Inflation, we expect the Fed to increase rates by almost 150 bps in the next 18 months. A higher yield could help the U.S. dollar and propel USD/JPY to 120.

This week, the release of inflation figures for several countries is likely to catch the attention of many traders. Indeed, we expect consumer prices to increase to record levels but also to be close to peaking since energy prices are significantly lower than they were in the previous month. In this article, we argue for more dollar strength in the months ahead. Currently, the U.S. dollar offers negative interest rates when adjusted by inflation and the U.S. Federal Reserve could be pressured to increase rates faster than traders had previously expected.

Why inflation matters to currency trading?
Last week, we had several central banks announcing their interest rate decision. Yet, despite their different economic circumstances they all have the same concern. In fact, despite the recent easing in the price of oil, central bankers remain concerned with inflation and second round effects of the spike in energy prices. But why inflation matters to currency trading? Inflation is one of the most important indicators used by central banks to make interest rate decisions and since yield differentials have been the main drivers behind many trends in the currency market, inflation indicators do matter for the forex trader.

Forecast for the U.S. dollar based on Real Interest Rates
Currently, the U.S. dollar offers negative real interest rates because the U.S. Federal Reserve believes there are still some down side risks to growth. In fact, the recent strength in economic activity reflects more the spending of taxes rebates than anything else. Yet, the substantial easing of monetary policy to date should help to rescue the U.S. economy from technical recession and going forward the main concern will be price stability. We expect the Federal Reserve to increase rates by 144 bps in the next 18 months and dollar strength to continue. We expect EUR/USD to trade below 1.45 in 3 months and USD/JPY above 120 in 6 months.