Dollar retreats ahead of Fed decision; cooling inflation weighs on sterling

WASHINGTON: The dollar edged lower on Wednesday ahead of a much-anticipated interest rate decision by the U.S. Federal Reserve later in the day, while sterling slid on increased bets the Bank of England (BoE) will pause its historic run of interest rate hikes. The U.S. dollar index, which measures the currency against a basket of rivals, was 0.2% lower at 104.86. The index rose for its ninth straight week last week, its longest winning streak in nearly a decade as resilient U.S. growth has fueled a rebound in the dollar, though the rally will likely be tested by Wednesday's Fed decision and commentary.

"The market, I think, has been surprised by the strength of the U.S. economy," said Stuart Cole, chief macroeconomist at Equiti Capital in London, said. "You go back to last year, and even earlier this year, and a lot of people had been expecting the Fed to be cutting by now. But it has not happened," Cole said.

Markets expect the Fed will almost certainly keep rates on hold at 5.25% to 5.50%, putting the focus on the central bank's forward guidance. "The market is expecting a pause, but with the language still erring on the hawkish side," Cole said.

"The risk is that it is more on the dovish side, which could potentially be USD negative," he said. The pound was volatile, last down 0.06% to $1.24 after touching 1.2334, its lowest in almost four months following data showing UK inflation slowed more than expected in August British annual consumer price inflation (CPI) unexpectedly fell to 6.7% in August, official data showed on Wednesday, a day before the BoE is expected to raise rates again.

Economists polled by Reuters had forecast CPI would rise to 7.0% from July's 6.8%. Dominic Bunning, Head of European FX Research at HSBC, said softness in core and services inflation in particular should give some comfort and limit the BoE to a 25 basis points hike on Thursday, marking the peak in the cycle.

"It is likely that the market will (then) slowly start to see the next move in UK rates being down, not up," Bunning said. "This can drag GBP down, especially against the USD where pricing for rate cuts may already be overstretched."

Money markets have started to price in an almost 60% chance the BoE will keep rates on hold on Thursday after 14 back-to-back increases stretching back to December 2021. On Tuesday, they were pricing only a 20% chance of a BoE pause. Attention stayed fixed on the yen as U.S. and Japanese authorities heaped on fresh comments about the possibility of intervention.

The yen was up 0.07% versus the greenback at 147.71 per dollar ahead of the Fed decision. Japan's top financial diplomat, Masato Kanda, reiterated warnings on Wednesday, saying Japanese authorities are always in close communication on currencies with U.S. and overseas policymakers while keeping a close watch on market moves with a "high sense of urgency". Asked whether Washington would show understanding over another yen-buying intervention by Japan, U.S. Treasury Secretary Janet Yellen said overnight it "depends on the details" of the situation.