USD Weakness Could Continue To Stimulate Inflationary Pressures

• Economic theory stipulates that inflation tends to increase when an economy is operating above its potential (firms are likely to be using labor and capital very intensively), and generally slows down when the economy is operating below its potential.
• There have many kinds of model to predict inflation over time, usually deriving from the classical Phillips curve model, which looks at the inverse relationship between inflation and unemployment.
• However, traditional variables used to predict (core) inflation are the lagged values of inflation (AR(1) process), a lagged value of long-run core inflation expectations, a lagged value of the unemployment gap, a lagged of the supply shock variable (i.e. import prices) and a lagged value of changes in the nominal exchange rate.
• This chart shows the interesting relationship between the annual change in the broad USD index (Nominal Effective Exchange Rate) and US core CPI.
• Over time, its shows that periods of sharp USD depreciation tend to lead to higher core prices 18 months later.
• Will the inflationary pressures remain elevated longer than market participants expect if the USD keeps depreciating in the coming months?

Source: Bloomberg/MNI