Dollar exchange rates recouped some losses on Tuesday after U.S. Core CPI inflation printed hotter than expected at 0.5% month-on-month, suggesting the Federal Reserve still has work to do on bringing inflation lower, even if the financial system has been showing signs of stress lately.

The core print was more than the 0.4% consensus expectation but in the year to February, it slid from 5.6% to 5.5%.

The headline CPI inflation reading meanwhile cooled from 6.4% in January to 6.0% in February, which was as expected.

Shelter was by far the biggest component of the uptick in inflation, suggesting the breadth of price pressures was easing.

Above: Shelter is the largest driver of U.S. inflation at present. Image courtesy of @KathyJones, Charles Swaab & Co.

"The strength in core service prices increased the odds of a rate hike from the Fed next week, with just over 25bps being priced in, and that prevented a further depreciation in the USD," says Katherine Judge, an economist at CIBC Capital Markets.

These data might, however, not be enough to prevent the Federal Reserve from halting its rate hiking cycle in March as it temporarily sets aside its inflation targetting mandate to confront signs of stress in the financial system.

The failure of a number of U.S. banks of late has prompted the market to slash bets for future rate hikes, with some investment banks now expecting a cut.

The Dollar has fallen sharply in the wake of the failure of Silicon Valley Bank (SVB) and the market's rapid move to price out interest rate hikes.

The Pound to Dollar exchange rate extended its recent gains to 1.2188 in the wake of the inflation figures as it built on the 2.0% cumulative gain of Friday and Monday.

But the Dollar could find some relief if signs of financial stress begin to ease as this would suggest to the Federal Reserve that its targetted measures at containing the SVB fallout are working and therefore monetary policy would not be required to act as an additional lever.

"Consumer price inflation did not show many signs of cooling in the February CPI. Headline inflation rose 0.4%, with the core index up 0.5%. With more than a week to go until the next FOMC meeting, a 25 bps rate hike is still a distinct possibility if financial stresses ease," says Sarah House, Senior Economist at Wells Fargo.

The Dollar has fallen against all its peers over the one-week timeframe as the U.S. Fed is now expected by markets to be the only central bank amongst developed peers to engage in rate cuts in 2023, according to money market pricing.

Downside risks to the currency would however fade if the Fed sees through the recent turmoil and reiterates its commitment to bringing inflation under control.

"In isolation, the labor market and inflation data clearly argue for another 25 bps rate hike at the March 22 FOMC meeting," says House.

But Wells Fargo joins peers at Goldman Sachs and Barclays in leaning towards a "pause" at the March meeting so that policymakers can digest the significant developments of the past week.