The dollar rallied on the unanticipated increase in CPI inflation today. For some, this appreciation would seem surprising. Increases in inflation are usually expected lead to a depreciation of the currency. Depreciation is what relative purchasing power parity would suggest. PPP models have been the workhorse for many analysts who have been arguing that the dollar fall-off is overdone, yet today was one of the bigger positive dollar moves in months.
The explanation can be found in looking at monetary policy reaction functions. A Taylor rule reaction function would argue for tightening of interest rates if inflation starts to move above target. His would be all the more likely if growth has not fallen significantly. The monetary expectations story is consistent with what happened in the equity markets. Without expected added liquidity, the market does not see a favorable environment for stocks of the next few months.
A significant portion of the recent dollar decline has been interest rate driven. The dollar decline went into overdrive with the cuts from the Fed. With the Fed easing, the interest differential has become less favorable for the US, so the dollar has trended lower especially against the euro. Additionally, the ECB has been firm at current rates even with the increase in supply of funds to meet credit crisis liquidity demands. The higher inflation today suggests that the Fed will be less likely to lower rates early in 2008; consequently, the fall in interest rates should stall. This change in monetary expectations is the current leading driver for the dollar. Whether this will be a short or longer-term dollar rally is hard to say, but there is little changed in the dollar fundamentals except for the possible delay in monetary easing.
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