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- US inflation has steadily cooled since mid-2022, thanks to large interest-rate increases by the Federal Reserve.
- However, a four-month drop in the dollar is threatening to derail that trend by raising the cost of imported goods.
- The dollar index has fallen by more than 11% from a peak reached in late September.
US consumers are getting used to being pleasantly surprised by cooling prices each month, with inflation extending a sustained decline thanks to the Federal Reserve's interest-rate hikes.
Annual increases in the Consumer Price Index slowed to 6.5% in December, the least in over a year, as disruptions to global goods supply chains caused by COVID-19 eased.
But the welcome relief on the prices front is now facing a new threat — in the form of a falling dollar.
The greenback is extending losses in January, after sliding almost 8% last quarter in the worst three-month slump in over 12 years. A weaker dollar raises the cost of imported goods, which would eventually feed into consumer prices in the US.
Why is the dollar falling?
The US currency has been in steady decline since end-September, and that largely represents a reversal of the trend that was in place from mid-2021 through the first nine months of 2022.
The dollar notched a stellar 17% gain during the three quarters of last year, buoyed by demand for its safe-haven status amid an adverse economic environment — marked by 40-year high inflation and a stock-market slump. In addition, the currency's appeal was burnished by the Federal Reserve's aggressive interest-rate increases, which boosted the yield on the greenback.
But the tide has been turning in recent months. A sustained moderation in inflation has tempered the odds of further Fed rate increases, while the reemergence of China's economy from pandemic restrictions has helped spark a rebound in emerging-market assets.
These factors have diverted investment flows away from the US currency, fueling its decline. The dollar index, which tracks the greenback against a basket of currencies, has fallen more than 11% from its late September peak.
A dim outlook for the US economy, which has lessened its safe-haven appeal, a softening outlook for interest rates, China's reopening and lower energy prices in Europe have all contributed to the dollar's weakness, Francesco Pesole, an FX strategist at ING, told Insider.
Signs of reflation?
The dollar's slump tells us several things about global markets, but it might have troubling implications for the domestic economy too.
Changes in currency rates can have an inverse impact on a country's inflation in subsequent months, according to a recent research note from Goldman Sachs. In other words, declines in a country's exchange rate can raise the cost of imported goods and lead to increased inflationary pressures.
The US is a net importer of materials such as lumber and semiconductors that are crucial in manufacturing supply chains, and these would become costlier due to dollar weakness. The price of overseas travel would also increase, adding costs for American consumers.
More important is the effect of a declining dollar on global economic activity, according to Danske Bank's head of FX and corporate research Kristoffer Kjær Lomholt.
"If we continue to see the dollar trade at current levels or even increase in weakness, that would be a headwind in the fight against high global inflation," Lomholt told Insider.
That's because a weak dollar spurs economic activity outside the US — fueling price pressures that could eventually filter back to America, putting more stress on the already tight labor markets.
Still, the dollar's recent declines are unlikely to raise the inflation alarm for US policymakers anytime soon, according to ING's Pesole.
"A weaker domestic currency is generally bad news for an economy that is trying to fight inflation," he said. "However, given how much the dollar strengthened in 2022, the recent decline is unlikely to sound the alarm at the Treasury's/Fed's and encourage more monetary tightening simply to support the currency."