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10August2017USEconomicPerspectivesNorthAmericaUnitedStatesEconomicsUSEconomicPerspectivesDate10August2017DeutscheBankResearchDollardepreciationisamodesttailwindforinflation■Thetrade-weighteddollarhasfallenmorethan2%inthepastmonthandnearly7%thisyear,leavingitnearitsweakestlevelssincemid-2015.Atthesametime,FedofficialshaveonbalancesoundedmoreconcernedaboutsoftinflationandanarrativehasemergedthattheUSisstuckinalowinflationregime.Isthislackofexcitementaboutthepositiveeffectsofaweakerdollaroninflationjustified,oristhemarketmissingapotentialcatalystforhigherinflationinthecomingquarters?■BasedonourowninflationmodelsandanalysiscitedbyFedofficials,recentdollarweakness–assumingthatitdoesnotreverse–couldliftyear-over-yearcorePCEinflationbyabout0.2percentagepointsbymid-2018and0.1percentagepointsbymid-2019.Theactualimpactwouldbelargerifthedollarcontinuestodepreciateorifweaccountforsecond-ordereffectsoninflationthroughstrongergrowth,thoughthelatterislikelytobelimitedgivenarelativelyflatPhillipscurve.■Althoughnotagamechangerinisolation,thetimingofthispeakresponsesuggeststhattheweakdollarcouldprovideamodesttailwindtocorePCEinflationatatimewhenotherfactors–includingpositivebaseeffectsfromrecentsoftinflationprintsandanunemploymentrateexpectedtobebelow4%–shouldalsobesupportive.■Takentogether,weexpecttheseforceswillhelppromoteasustainableriseincoreinflationbeginningaroundQ2ofnextyear.Therefore,incontrasttothistimetwoyearsagowhenconcernsofcoolingcoreinflationdominatedtheFed’sJacksonHoleconference,thebackdroptothemostrecentsoftspellisverymuchdifferent.Atthattime,depressedenergypricesanda15%surgeinthedollarwereexpectedtodelayareturntotarget.Atpresent,thesedynamicsshouldsupportamorebalancedassessmentofinflationrisksformonetarypolicymakers,helpingtoreinforcethemedianFOMCforecastofthreeratehikesnextyear.■Ifcoreinflationfailstoshowsignsofimprovingsustainablyaroundmid-2018withvarioussupportingfactors,theFedmaybeforcedtore-thinktheircurrentbaselineviewthatatighteningeconomywilleventuallyhelpliftinflationtotheirtarget.MatthewLuzzetti,PhDSeniorEconomist+1-212-250-6161PeterHooper,PhDChiefEconomist+1-212-250-7352BrettRyanSeniorUSEconomist+1-212-250-6294DeutscheBankSecuritiesInc.DISCLOSURESANDANALYSTCERTIFICATIONSARELOCATEDINAPPENDIX1.MCI(P)083/04/2017.Distributedon:10/08/201709:39:07GMT0bed7b6cf11c10August2017USEconomicPerspectivesIntroductionThetrade-weighteddollarhasfallenmorethan2%inthepastmonthandnearly7%thisyear,leavingitnearitsweakestlevelssincemid-2015(Figures1and2).Atthesametime,FedofficialshaveonbalancesoundedmoreconcernedaboutsoftinflationandanarrativehasemergedthattheUSisstuckinalowinflationregime.Isthislackofexcitementaboutthepositiveeffectsofaweakerdollaroninflationjustified,oristhemarketmissingapotentialcatalystforhigherinflationinthecomingquarters?Figure1:USdollarnearweakestlevelssincemid-201510010511011512012513010010511011512012513014151617IndexIndexNominalbroadtrade-weightedexchangevalueoftheUS$(Jan97=100)Source:FRB,HaverAnalytics,DeutscheBankFigure2:Thedollarhasfallensharplythisyear-10-505101520-10-505101520959799010305070911131517%chg,26-week%chg,26-weekNominalbroadtrade-weightedexchangevalueoftheUS$(Jan97=100)Source:FRB,HaverAnalytics,DeutscheBankWeprovideadetailedassessmentofhowrecentdollarweaknesscouldaffecttheUSinflationoutlook.HistoricalbackdropTheeffectofexchangeratechangesoninflationhasbeenasubjectofempiricalanalysisfordecades,datingbackatleasttotheadventoffloatingexchangeratesintheearly1970s.Largeswingsupanddowninthedollar'svalueagainstmajorcurrenciesinthe1980sadvancedandthenslowedtheFed'seffortstobringUSinflationdowntodesiredlevels.Inthelatter1990sthebroadweightedaveragedollarjumpedmorethan20%andheldinflationincheckasthelabormarkettightenedsubstantiallyabovefullemploymentlevels.Asimilarsurgeinthedollaroccurredmorerecentlyfrommid-2014through2015.FedViceChairFischerspokeinsomedetailaboutthepotentialimplicationsofthisrun-upinthedollarforUSinflationatJacksonHoleandlaterintheyear.12Atthetime,theannualgrowthrateofcorePCEinflationwasaround1.3%,oilpricesweredown55%fromtheprioryearandthenominaltrade-weighteddollarhadrisenover15%.Inthesespeeches,Fischeremphasizedthattherecentdollarstrengthwouldexertasignificantdragontheinflationoutlook.Inparticular,henotedthatFedmodelsimulationsfindthata10%dollarappreciationwouldlikelydepresscorePCEinflationby0.3-0.5%overayear.Thisdragwoulddiminishover1SeeFischer,Stanley(August29,2015),“USinflationdevelopments.”SpeechattheFederalReserveBankofKansasCityEconomicSymposium,JacksonHole,Wyoming,and2Fischer,Stanley(November12,2015),“Thetransmissionofexchangeratechangestooutputandinflation.”Speechatthe“Monetarypolicyimplementationandtransmissioninthepost-crisisperiod”conference.Page2DeutscheBankSecuritiesInc.10August2017USEconomicPerspectivesaperiodofseveralyears,withtheeffectslikelyatorbelow-0.1%withintwotothreeyears.Intheevent,thedragonUSinflationmayhavebeenlessthantheseestimatessuggested,andcentralbankeasingabroad,coupledwiththeFed'sretreatfromitsoriginalplantohikefourtimesin2016couldhavemitigatedtheseeffectssomewhat.Indeed,whiletheSeptember