NEWS / Monetary Policy

FOREX-Dollar bounces back as Fed points to inflation risk

(Updates prices, adds detail)

By David McMahon

NEW YORK, May 31 - The dollar climbed on Wednesday, hitting session highs after minutes from the Federal Reserve's latest policy meeting suggested that the central bank was still concerned about inflation.

Although the minutes from the May 10 meeting showed that policy makers were not certain how much more monetary tightening, if any, was needed, a mention that inflationary pressures were rising helped reinforce expectations for more rate rises.

Reflecting a view that the Fed could extend its run of rate hikes from as early as its next meeting in June, the 2-year U.S. Treasury yield shot to a 5-1/2 year high and the dollar rose across the board.

"Markets viewed it as ever so slightly dollar bullish," said Tim Mazanec, senior strategist at Investors Bank and Trust in Boston. "My initial impression is they're still talking about the potential for further policy firming."

Earlier in the session the dollar had posted solid gains, bouncing back from heavy losses in the previous session, as a bullish cocktail of stronger U.S. data and a drop in the price of oil and gold whet investor appetite for the greenback.

The dollar also benefited from remarks from U.S. Secretary of State Condoleezza Rice, who said the United States would join key European countries in talks with Iran if Tehran suspended its nuclear enrichment program, marking a major policy shift. See [ID:nN31131486] for details.

By late afternoon in New York, the euro <EUR=> was at $1.2810, down 0.5 percent on the day, after earlier falling as low as $1.2805. The dollar was up around 0.4 percent at 112.55 yen, while sterling <GBP=> was down 0.75 percent at $1.8705.

Earlier on Wednesday the dollar also gained support from data showing the Chicago Purchasing Management index rose to a seven-month high in May of 61.5, far better than economists' median forecast of a fall to 56.0. For details, see [ID:nNYH000201].

On Tuesday, the greenback suffered its biggest daily loss against a basket of currencies since early January <.DXY> after the nomination of Goldman Sachs Chairman Henry Paulson to succeed John Snow as Treasury secretary did little to dispel a market view that Washington favors a weaker dollar to help narrow its gaping trade deficit.

Partly due to such a perception the dollar has been under pressure since November, sliding 8 percent against a basket of the currencies of six major trading partners. A view that the Fed's string of dollar-boosting rate hikes is drawing to an end have also hurt the greenback.

In the near term, analysts say the dollar's direction will likely be determined by a nonfarm payrolls report on Friday, which will give an update on the strength of the U.S. labor market, and perhaps some insight into whether the Fed will raise rates higher.

"The bottom line is there does appear to be some uncertainty in terms of how much more tightening is required," said George Davis, senior currency strategist at RBC Capital Markets in Toronto.

The Fed, which has raised rates 16 times in a row since mid-2004 to 5 percent, is seen to be in the difficult position of having to weigh the risk for higher inflation against concern over a slowdown in the housing sector.

(Additional reporting by Amanda Cooper, Steven C. Johnson and Nick Olivari)