Pound Eyes 2023 High Against Dollar in Wake of U.S. Inflation Undershoot

• CPI (MoM) Actual: 0.1%, Expected: 0.2%, Previous: 0.4%
• CPI (YoY) Actual: 4.0%, Expected: 4.1%, Previous: 4.9%
• Core CPI (MoM) Actual: 0.4%, Expected: 0.4%, Previous: 0.4%
• Core CPI (YoY) Actual: 5.3%, Expected: 5.3%, Previous: 5.4%

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The Dollar was sold after official figures confirmed U.S. inflation is falling sharply amidst an ongoing decline in the price of energy and a broader easing of price pressures, opening the door for the Federal Reserve to keep interest rates unchanged on Wednesday.

Fuel oil lead the way lower with a decline of 7.7% and utilities fell by 2.6% month-on-month. Upward pressure came from food and shelter and used cars, up 0.2%, 0.6% and 4.4% respectively.

The downward reaction of the U.S. Dollar to the data suggests the market is now fully priced for the Fed to maintain rates at current levels on Wednesday while also lessening the need for the central bank to strike a 'hawkish' tone.

"Anything other than a pause in interest rate hikes at this stage could endanger economic stability, with certain data points revealing the tremendous pressure the US economy is currently under," says Oliver Rust, head of product at Truflation.

Truflation’s index, which is compiled using millions of data points measured in real-time, is showing live U.S. CPI at 2.74% - much closer to the Fed’s target of 2%

"It's a feel-good headline figure that will cheer investors as it will add further pressure on the Fed to pause its interest rate hike agenda," says Nigel Green, CEO and founder of deVere Group.

The Pound to Dollar rose to 1.26 on the back of the data as the Dollar index retreated 0.40%. The Euro rose 0.40% against the Dollar to quote at 1.08.

Above: GBPUSD at daily intervals.

"The US central bank is now 15 months and 10 consecutive rate increases into its battle to cool red-hot inflation, but markets will be expecting that the latest CPI report will now be enough to convince officials to hit the pause button," says Green.

Key for the FX market outlook will be how the Fed guides market expectations at its midweek policy event. Economists note that although inflation has fallen it remains positive and above target, a reality that should keep the Federal Reserve on guard.

"Inflationary pressure will tend to ease this year. However, due to the high underlying inflationary pressure, inflation should ultimately remain above the Fed's target," says Christoph Balz, Senior Economist at Commerzbank. "Underlying inflation remains far too high at levels around 5% on an annual basis."

Of particular concern to policymakers will be a desire to ensure the market does not price rate cuts prematurely. Hence, the wording and tone set out by Chair Jerome Powell on Wednesday could yet offer the Dollar some support.

Nevertheless, the Dollar's May rebound looks to have faded and more losses beckon over the coming weeks as investors get a clear sense that the peak in rates is now visible.

For GBPUSD, the next target would be the 2023 high at 1.2679 but any break above here looks a difficult task given the heightened caution likely ahead of the June 21 UK inflation release and the June 22 Bank of England interest rate decision.