Pound-to-Dollar Sinks into the Red as Inflation Prints Backs Fed Caution

Image © Adobe Images

The disinflation trend in the U.S. is at risk of stalling.

The pound to dollar exchange rate extended its retreat from the day's highs after U.S. inflation data signalled the Federal Reserve must proceed cautiously when considering further interest rate cuts.

The pair fell to 1.3469 from 1.349 after U.S. inflation met consensus expectations at 2.7% y/y. The core rate read at 2.6%, placing it below expectations for 2.7% y/y.

However, these data show inflation is running well ahead of the Fed's target of 2.0% and signal that the disinflation trend risks dying out completely.

"The monthly CPI increase for December was a relatively high 0.3%, which justifies the Fed's caution when it comes to signalling the prospect of further rate cuts this year," says Kathleen Brooks, research director at XTB.

The Federal Reserve lowered interest rates three times in late 2025 and has since indicated it would move cautiously.

That caution is, on balance, supportive of U.S. bond yields and the dollar.

In short, there was no 'smoking gun' in today's data that would encourage the Fed to quicken the pace at which it cuts rates, which is supportive of the dollar.

The U.S. currency has been on the rebound in early 2026, rising in value until news broke that the U.S. Justice Department was pursuing legal action against the Federal Reserve and its Chairman, Jerome Powell.

The move is universally seen as an attempt by the White House to exert influence over the Fed and pressure it to lower interest rates.

However, Powell stressed in a statement delivered on Sunday that the Fed must base its decisions on economic fundamentals.

With inflation running above target, and signs of disinflation fading, the message is clear: rates could prove sticky at current levels.

Above: Expectations for Federal Reserve's base rate as per money market pricing. It shows the Fed isn't expected to cut as deeply as was assumed back in October.

Should fears about the Fed's independence fade, the data could help the dollar resume the recovery that characterised the opening days of 2026, putting GBP/USD back under pressure.

Going forward, much will also depend on the labour market; after all, the Fed is tasked with targeting inflation and employment.

The economy isn't creating the jobs it once was and this is why the Fed cut interest rates three times in late 2025.

If upcoming jobs data confirms this trend, the Fed could yet choose to look through the still-high inflation numbers, judging that stability in prices can allow them to target the labour market more aggressively.

"As for the Fed, notwithstanding its issues with the Department of Justice, it should stay on the sidelines at its next meeting. However, if inflation and job creation remain sluggish, pressures could build for additional policy rate cuts later this year," says

Expectations for Fed rate cuts in the coming months have receded over recent weeks (the line in the chart above has lifted), and that's provided the fundamental support to the dollar we've noted already in 2026.

However, if markets begin pushing in the other direction again - for more rate cuts - the dollar will lose support once more, and it will likely be on account of the jobs market deterioration.