Can Fed caution slow the dollar’s bull run?

The dollar has been hovering close to one-year highs buoyed by a modest rise in inflation and a cautious stance from the Fed, as inflation rose slightly to 2.6% in October. Investors are now closely monitoring Fed officials’ statements.

We’ve seen the USD making significant progress against both the EUR and GBP in the 90 day picture, even before Trump’s victory at the polls at the start of the month. GBP was already off against the USD on the back of the Rachel Reeves budget in the UK, while the Euro has also been steadily sold against the greenback, bar a slightly rally in the last 10 days before the US went to the polls.

Jerome Powell says he’s taking a cautious approach

Fed Chair Jerome Powell said this week he was taking a cautious approach to cutting rates. The Fed is looking at a still robust US economic situation, with a solid job market and inflation rates coming in around the 2% target. “The economy is not sending any signals that we need to be in a hurry to lower rates,” he said in a speech in Dallas.

The remarks follow a slight uptick in inflation last month. We’ve seen the tacit acceptance by the market of higher US inflation; now it’s moving into the explicit phase, according to some forex analysts.

“The Fed will probably be quite happy with a market crash,” said forex market analyst Neil Wilson at Finalto. “I find the idea of a market correction coming early next year as the long end of the yield starts to blow out quite compelling.”

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Examining tariffs and inflation

The US economy seems in pretty good shape: but President Trump’s tariffs on imports last time around led to job losses and higher prices. “We find that tariff increases enacted in 2018 are associated with relative reductions in manufacturing employment and relative increases in producer prices,” one 2019 report by Fed economists Aaron Flaaen and Justin Pierce said.

The presidents of the Dallas and St Louis Fed have expressed optimism that US inflation will continue to gradually return to the 2% target. However, Dallas Fed president Lorrie Logan noted that, while rate cuts may be needed to sustain economic growth, the Fed should proceed with caution. This suggests that any easing of monetary policy could occur gradually, potentially limiting any immediate downward pressure on the dollar.

Adding to the dollar’s momentum are the concerns surrounding the incoming Trump administration. With Republican control of Congress, policies aimed at boosting inflation, including higher trade tariffs, are more likely, which may delay the Fed’s rate-cutting cycle.

The probability of a 25-basis-point rate cut in December has fallen from 75% to 59.1%, reflecting increasing market caution regarding future expectations.

Tariffs and the US dollar

Tariffs are generally seen leading to higher inflation. If Trump presses ahead with the toughest set of tariffs imaginable then it would exert upwards pressure on prices – but probably just once. And the Fed has said in the past it’s probably best to look through the one-off effect rather than crash the economy by hiking.

Asked about this, Powell repeated that it was too soon to say how the Fed would address potential policy changes; though he did allow that, “we’re in a different situation” today versus six years ago, when inflation had been low and anchored inflation expectations hadn’t been meaningfully tested.

This is an important point- not only might tariffs be an order of magnitude greater than last time, but the inflation paradigm has changed from ‘we cannot get any inflation’ to ‘2% is now the floor’. “This is tariffs after the toothpaste is out of the tube,” Finalto’s Wilson explained in a briefing to traders this week.

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