The US dollar tumbled in the second part of last week and continued to develop a correction on Monday after the market was upset by weak data on consumer inflation in the US released last week. The increase in price levels in April received major support from the energy component, as oil rose by 11% since mid-April. The core indicator of inflation, not including energy and food, fell behind the forecasts by 0.1% in April, showing that the amount of “headwinds” in the US economy is increasing.
In the long run, the inflation rate depends largely on the growth of money supply. In the short term, inflation may be hampered by shocks shifting the curves of aggregate supply and demand. To understand the mechanics, it is useful to break down the shifts in these curves on the inflation-output chart:
On the side of aggregate supply, these are fluctuations in labour supply: a decrease shifts the AS curve to the left, as wage growth increases with a shortage of labour. This has two effects; increased labour costs force firms to respond by increasing consumer prices, whereas employee income growth allows them to increase consumer spending. The result is that the AD aggregate demand curve shifts to the right upwards, thus increasing inflationary pressures.
On the side of aggregate demand, the same effect is caused by an increase in money supply or a decrease in speculative demand for money, since this type of demand inversely depends on the nominal interest rate, which has inflation as a component.
This explanation is given in the framework of one of the theories of money demand, called liquidity preference:
As for the transactional demand (the demand for money as a means of exchange), it has a direct relationship with the nominal interest rate, e.g. the rise of this type of demand also increases inflation. Translating this into the language of macroeconomic statistics, key indicators that give information about inflation are wage growth, the indicator of consumer confidence, consumer spending, retail sales, and an increase in yield on fixed-income market (bond market).
Wage growth for the last three months did not exceed 0.2%, shifting the risks to the downside for inflation. Consumer confidence remains high, as shown by the confidence index from U. of Michigan, which surpassed expectations by 0.5 points in May (preliminary data). With small fluctuations, it holds about 100 points, which means that confidence is very high. Retail sales, such as consumer spending, recovered at the end of the first quarter, following a slowdown at the beginning, that was most likely caused by seasonal factors (the weather, “dead” months after the New Year holidays, etc.).
Yield to maturity on 10-year treasury bonds reached almost 3% (even higher than last week.) The rise was triggered by the rally in oil prices, which run out of steam amid uncertainty over Iran’s share in the world oil supply.
The last and most likely factor that played a role in slowing inflation remains, oddly enough, the US dollar. Strengthening of the national currency means an increase in demand for it, and as can be seen from the soaring yields of the US Treasury bonds (i.e., falling demand in the bond market), the speculative demand for the dollar increased. Since the speculative demand for the dollar adversely affects the nominal interest rate (which includes inflation), it should have slowed down what happened.
In fact, the slowdown in inflation does not have the nature of a macroeconomic problem but has a speculative nature. The US economy itself, as the data show, is still normal. Another issue that caused it is the outflow from the US bond markets. The answer suggests itself; an increase in oil prices, expectations that companies will see increased costs, and hence increased prices for consumer end products. In fact, inflation expectations caused a slowdown in inflation, which occurred in April.
From this point of view, further medium-term growth of the dollar is questionable, because everything depends Fed reaction the current events. If it decides to focus on the health of the economy, it will continue to give moderately aggressive hints. If it considers that the strengthening of the dollar is a threat, it will try to neutralize this factor.
From this point of view, a further medium-term growth of the dollar is questionable, because everything depends on Fed’s reaction to the current events. If it considers that the strengthening of the dollar is a threat, it will try to neutralise this factor.