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#1 17-08-2020 10:41:55

johnedward
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From: Paris - France
Registered: 21-12-2009
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EUR/USD: dollar is declining even though the CPI points to inflation

EUR/USD: the dollar is declining even though the CPI index indicates an increase in inflation


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The above title may confuse traders, but there is logic behind it. The logical interpretation is that when inflation increases, the value of a currency decreases. But, and this is a big but, this only applies if inflation exceeds the central bank's target.

Most central banks have had an inflation target for some time now. This means that the central bank considers a certain level of inflation to be ok for economic growth. To combat deflation, worst of all, central banks are prepared to let inflation fall below 1.9%, but close to that level.

In the United States, the Fed does not explicitly target a certain level of inflation. Rather, it has a dual mandate - one that focuses on both job creation and price stability (also known as inflation).

Why did the USD decline after optimistic inflation data?

Last week, the U.S. Consumer Price Index (CPI) showed much higher than expected inflation. The month-to-month headlines showed that inflation doubled, while the most important measure, the core CPI, tripled! Core inflation or core CPI refers to data that excludes energy prices, such as oil and transportation, which are considered too volatile.

Despite the increase in inflation, it only went from 0.19 to 0.59 on the core data. In other words, well below the Fed's 1.9% target. This actually means that, while remaining below the target, the Fed is fulfilling the price stability component of its mandate.

As a result, the market simply ignored the CPI data. Normally, with inflation tripling as was the case with core CPI, the USD should gain in value. Why?

Under such circumstances, there is a growing expectation that the Fed will step in and raise rates. Or, at the very least, it is expected to change its tone at the next FOMC meeting, signaling a tightening of conditions ahead.

Returning to the headline, the USD has fallen because inflation, even if it triples on a monthly basis, is still well below the Fed's target. The closer it gets to the target, the less the USD will decline as the Fed will intensify and modify its monetary policy.

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