EUR/USD: this Friday's inflation data will move the dollar

Rising inflation expectations in the US have led to a fall of the USD. What will happen when real core inflation rises?

This Friday, the US will release the monthly Core PCE data. The acronym stands for "personal consumption expenditure" and represents the evolution of the price of goods and services purchased by consumers. As this is a 'core' publication, this means that energy and food prices are excluded as they are considered too volatile.

Investors are interested in the Core PCE data for several reasons. First, recent inflation data from the world's largest economy indicate a larger rise in prices than originally estimated. Second, the Core PCE is the Fed's preferred tool for measuring inflation.

Higher inflation in the US - good or bad for the dollar?

Rising inflation means a depreciation of the currency. This is the case for all fiat currencies, but the US dollar has the distinction of being the world's reserve currency.

The Fed took the markets by surprise last Wednesday. The FOMC minutes revealed that some Fed members are aware of the need to reduce asset purchases in the near future - a sign that rising inflation in the US does not leave Fed members indifferent.

To interpret inflation, one needs to understand the difference between nominal and real rates. Real rates coupled with inflation constitute the nominal rate. The problem here is that the current environment has led to the lowest US real rates on record, which means that the inflation premium is a more important component of the nominal rate.

According to a study by Nordea, a European investment bank, the dollar index (DXY) has actually risen during periods of high inflation. The study focused on the 1970s, a period characterised by higher inflation in the US.

In order to interpret the effect of inflation on the DXY, it is necessary to distinguish between inflation expectations and the evolution of actual core inflation. It seems that when inflation expectations are rising, as has been the case recently, the US dollar falls against its peers. On the other hand, when real core inflation starts to rise, the US dollar is king, as the historical data shows.

All in all, this Friday we will have the opportunity to test this theory. Depending on how the market reacts to the Core PCE data, traders may get an idea of what to expect for June.