Bank of America Warns: Dollar Faces 8% Drop if Fed Cuts Rates Amid Rising Inflation

Bank of America has issued a warning that the U.S. dollar may face a significant challenge: the Federal Reserve is considering lowering interest rates despite an annual inflation rate that is on the rise. The last time such an unfavorable situation occurred was nearly twenty years ago. The foreign exchange strategist at Bank of America stated in a report on Thursday, "If the Federal Reserve restarts the rate-cutting cycle, any rate cuts in the remaining time of 2025 could occur against a backdrop of rising year-on-year inflation. While this situation is possible, it is historically rare."

The strategist noted that the last time the real policy interest rate was suppressed was during the second half of 2007 to the first half of 2008. During this period, the Bloomberg Dollar Index fell by approximately 8%. Historical analysis shows that the depreciation of the dollar began before the Federal Reserve cut rates (similar to the situation this year) and continued even after the rate cuts.

From the second half of 2007 to 2008, supply shocks drove up global food and energy prices. Despite this, the Federal Reserve lowered borrowing costs because the U.S. housing market and labor market began to show signs of weakness. Currently, the Federal Reserve must address economic uncertainty caused by the tariff policies of Donald Trump, as well as a weakening labor market. Market participants expect an 85% chance of a 25 basis point rate cut by the Federal Reserve in September, despite July's inflation rate rising at its fastest pace since January and producer prices exceeding expectations.

Bank of America estimates that by the end of this year, even if the overall monthly increase in the Consumer Price Index (CPI) remains around 0.1%, the year-on-year increase will reach approximately 2.9%, higher than the mid-2025 level. The strategist and colleagues recently took a bullish stance on the euro against the dollar, targeting a 3% increase in the euro-dollar exchange rate by the end of this year, to 1.20.

The Bloomberg Dollar Spot Index has fallen by approximately 1.3% so far in August and by approximately 8% for the year to date. This is the worst start to the year for the index since 2017. The two-year U.S. Treasury yield, seen as the most sensitive to Federal Reserve policy, has fallen by approximately 50 basis points so far this year.

If the Federal Reserve cuts rates this year, this rare combination of inflation and rate cuts has not been seen since the second half of 2007. The strategist noted that the last time the real policy interest rate was suppressed was during the second half of 2007 to the first half of 2008. During this period, the Bloomberg Dollar Index fell by approximately 8%. Historical analysis shows that the depreciation of the dollar began before the Federal Reserve cut rates (similar to the situation this year) and continued even after the rate cuts.