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How Inflation Responds to a Declining Dollar

The dollar’s value has dropped throughout the year, which could lead to a spike in inflation. But it remains unlikely that currency markets will influence the long-term outlook for interest rates.
Jim Glassman, Head Economist, Commercial Banking
August 23, 2017

The dollar has declined steadily throughout 2017, and its diminished purchasing power should logically lead to higher prices for imported goods and services. However, the dollar’s fall is unlikely to cause a sustained spike in inflation, as currency markets typically reflect underlying economic trends, rather than triggering reactions. Consequently, foreign exchange developments will likely only play a tangential role in the Federal Reserve’s upcoming decision regarding the pace of interest rate normalization.

A Weak Connection

The dollar has fluctuated quite wildly over the past decade, but its variability hasn’t had a lasting impact on inflation. In 2009, when the Fed launched its quantitative easing program, the dollar dropped by approximately 15 percent against the currencies of the country’s largest trading partners. When the Bank of Japan and European Central Bank followed suit with their own asset-purchasing programs in 2013 and 2014, respectively, the dollar rebounded, gaining about 20 percent against both the Yen and Euro.

Inflation usually echoes these currency movements, with the price of imported consumer goods rising and falling along with the dollar’s purchasing power. For example, in 2011, the dollar’s weakness briefly pushed core inflation to 2 percent; however, the US economy was still reeling from the recession, and the falling currency couldn’t sustain that rate of inflation.

Generally, currency values reflect broader trends rather than influencing them. Episodes of the dollar’s strength in the 1980s and 1990s were a sign of a booming domestic economy and US consumers’ expanding purchasing power. Similarly, developing nations like India that run persistently high levels of inflation can see their nominal currency values deteriorate even as the country’s real purchasing power climbs.

The Dollar Solidifies

Since 2015, the broad dollar index has seen relatively moderate moves. Last year the currency rose steadily on positive economic developments, but this year it has given back most of its gains. These recent movements have brought import inflation back into alignment with domestic inflation trends. Consumers have seen little impact on retail prices, perhaps a sign that importers are taking steps to blunt the falling dollar’s impact.

Historically, currency movements have played only a minor role in shaping the direction of the US economy. The tightening labor market, rather than the dollar’s value, is more likely to influence the outlook for inflation.

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