Dollar weakness: Declining US inflation paves the way for interest rate cuts

The dollar was on the defensive on Thursday and the euro was near eight-month highs after data showed a slowdown in U.S. inflation, supporting speculation that the Federal Reserve could cut borrowing costs next month.

The yen was stable at 147.26 against the dollar after data showed Japan's economy grew 3.1% faster than expected on an annual basis in the April-June period, recovering from the previous quarter on the back of a solid rebound in consumption.

In the US, data on Wednesday showed that the consumer price index rose moderately as expected and the annual increase in inflation slowed to below 3% for the first time since early 2021.

Combined with the slight increase in producer prices in July, these figures suggest that inflation is declining. However, traders now expect the Fed to be less aggressive in cutting interest rates as hoped.

Josh Chastant, public markets portfolio manager at GuideStone Funds, said both U.S. CPI and PPI data point to a 25 basis point rate cut by the Fed in September.

“Much will depend on the tone of the minutes and the post-meeting press conference, but markets could be slightly disappointed if there is only a 25 basis point cut,” he said.

According to the CME FedWatch tool, markets are now pricing in a 64 percent chance of a 25 basis point cut next month and a 36 percent chance of a 50 basis point cut. After last week's sell-off, traders were evenly split between the two cut options at the start of the week.

The markets expect the Fed to cut interest rates by 100 basis points this year.

“The green light for rate cuts remains on and the Fed is getting the disinflationary evidence it needs to gain the confidence to go ahead with its plan,” said Kyle Chapman, foreign exchange market analyst at the Ballinger Group.

“A 50 basis point cut would be a desperate move and would be based more on fear of growth.”

The euro was steady at $1.10110 in early trade and was hovering near $1.10475, the highest level since early January, which it hit on Wednesday. The single currency is up 0.86% on the week, and is set to post its strongest weekly performance in over a month.

sterling was little changed at $1.2826, after falling on Wednesday as a weaker-than-expected reading of UK consumer price inflation supported expectations of further interest rate cuts by the Bank of England this year.

The Dollar indexwhich measures the U.S. unit against six rivals, was last at 102.6, not far from the eight-month low of 102.15 it hit last week. The index is on track for its fourth consecutive week in the red, a stretch it last saw in March-April 2023.

Investors' focus will now be on US retail data due out later Thursday.

Elsewhere, the yen moved slightly away from the seven-month high of 141,675 reached during last week's market chaos.

Investors are still processing Japanese Prime Minister Fumio Kishida's decision to step down next month, but analysts said the news had a limited impact on markets.

The New Zealand Dollar was last little changed at $0.5997, having fallen more than 1% in the previous session after the Reserve Bank of New Zealand cut its key interest rate by a quarter point, its first easing since early 2020.

The Australian Dollar remained stable at USD 0.6595 ahead of the release of labor market data that could impact interest rate expectations.

A lower unemployment rate could prompt markets to scale back their pricing for a Reserve Bank of Australia rate cut this year and support the Australian dollar, said Kristina Clifton, senior economist at the Commonwealth Bank of Australia.