A basket of currencies as protection against inflation

In view of the sharp rise in US inflation ( + 4.2% YoY in April) and concerns that future inflation will be more permanent than transient , this publication reviews the relationship between consumer prices and exchange rates, notably the economic theory of purchasing power parity. We then examine the links between the US dollar’s effective exchange rate and consumer prices in the United States. There is some relationship between these two variables , but it has not always been stable over time. By contrast, there is a relatively high correlation between inflation and the rates of exchanges between commodity currencies and the US dollar. Given the correlation of these currencies against the dollar, we have used a quantitative approach to construct a basket of currencies offering protection against inflation. The weights of the selected currencies are readjusted each month applying the Kalman filter. Our inflation index, calculated in this way, has a correlation of more than 80% with US 5Y5Y inflation forward.