Brace yourself for the next inflation shock

How high the American inflation was in January will be known today (Wednesday 12 February). Rising prices undermine consumer confidence in the United States. But in the short term, higher inflation mainly leads to a further rise of the dollar. 

On currency markets, exchange rates have been swaying in recent weeks to Donald Trump’s tariff rhetoric. A week ago, Canada and Mexico seemed set to face US import duties. Those measures were quickly postponed, so the spotlight has shifted to a levy on European steel and aluminium. Trump’s unpredictable shock policy is having an indirect effect on the value of the dollar. If it becomes more expensive to bring goods into the United States, American consumers will sooner or later feel the effects. Recent polls show that Joe Sixpack can already see the storm coming. The University of Michigan announced last Friday that the average American expects inflation to reach 4,3% in twelve months.

Is a new inflation rally coming?
If that level is actually reached, it would be the highest level in almost two years. The big difference is that inflation was already well on its way in the spring of 2023, having started its slide from a level of over 9% the summer before. For now, it remains to be seen whether a new inflation rally is coming. Tomorrow, the Bureau of Labor Statistics will release the official figure for January. Economists expect it to be at the same level as the 2,9% of the previous month. If there are no major surprises, there will be little reason for the Federal Reserve to tinker with the policy rate. That will probably also be the message from Fed Chairman Jerome Powell, who will brief the US Congress this week.

Interest rate gap widening
For the time being, Powell and his fellow directors do not have to make a decision on the policy rate. That will not happen until March 19. A month ago, traders priced the chance of a rate cut at around 25%. That is now less than 7%. At the moment, the most likely scenario is that there will be a rate cut or even no rate cut this year. It therefore looks as if the interest rate differential with Europe will become even greater. While the American policy rate is 4,5%, the European Central Bank (ECB) uses a deposit facility of 2,75%. That will be reduced by 0,25 percentage points at the beginning of March. Inflation in the eurozone has indeed risen slightly each of the past four months to 2,5% in January, but the ECB is mainly looking at the faltering economic growth.

Take care
Lower interest rates make it more attractive to borrow money for new investments or consumer spending. Many economists therefore expect European interest rates to reach or even fall below 2% by the end of this year. Despite the growing interest rate differential – which makes it increasingly attractive to hold assets in dollars – the currency has been marking time for a few weeks. This pause is mainly due to the uncertainty surrounding Trump’s trade policy and some concerns about the dip in American consumer confidence. If attention shifts back to inflation figures and interest rate differentials, the dollar could resume its advance. It still looks as if the currency will be worth more than a euro before the turn of the year.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.