FYI | Jun 05 2014
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
This week we have had some key Fed members talk about US monetary policy, and both have mentioned inflation. The Fed’s Evans, a noted dove, mentioned that rates should not rise until the US is closer to the Fed’s 2% target for CPI, while the Fed’s Fisher, a well-known hawk, said that he is in favour of ending QE in October and after that will consider a rate hike based on the outlook for prices and job growth.
In recent years the focus has been on job growth, however, the Fed may be shifting its gaze towards prices in the coming months, since inflation data has been picking up. If this continues then dovish Fed members like Evans may need to change their tune.
In the past week there have been a number of price gauges that have caught our eye:
– The PCE deflator for April rose to 1.6% from 1.1% in March; this is the highest reading since November 2012. It is worth noting since the PCE deflator is an inflation measure that is looked at by the Fed, and could get the hawks excited.
– ISM manufacturing prices paid index rose to 60.0, back to recent highs, which suggests that the uptrend in factory price inflation remains.
– US non-manufacturing ISM prices have also been trending higher. This is significant since the service sector is the largest part of the US economy. In April non-manufacturing prices surged to their highest level since October 2012.
– Unit labour costs for the first quarter rose to 5.7%, the largest increase since Q1 2013.
– Headline CPI is close to the top of the range that has persisted since mid-2012, and core CPI is catching up, it rose to its highest level in 13 months in April.
So what is weighing on prices?
Food prices have been the main contributor after the bad winter weather. The trouble is that higher food prices easily flow through the inflation pipeline. As people need food to live, increases in food prices can lead to calls for higher wages, which can then lead to entrenched price increases. This is what the Fed wants to avoid, hence why the Q1 unit labour costs could trigger some discomfort among Fed members at its meeting on June 18th.
The Fed’s inflation target:
The Fed implemented its inflation target in January 2012, back then core CPI was running at a 2.3% annual rate, and since then inflation has been trending lower. Now that the tide is changing and the Fed’s inflation target is at stake, we will see just how important a 2% target is for the Fed. The Fed has a duel mandate and also has to ensure a strong labour market. Thus, another month of strong payroll growth could shift the focus firmly towards prices.
The market impact:
Inflation (as measured by the PCE deflator) has a historically close relationship with Treasury yields, as you can see in the chart below. So if inflation continues to pick up and if this historical relationship holds, then we could see Treasury yields also tick higher.
As we are only 4 months away from the end of QE, if price pressures start to build at this stage then it could be the perfect storm for yields, which have fallen sharply this year. Thus, when Treasury yields fell to 2.4% last week this could be a medium-term low for yields, which could support a dollar rally in the medium-term.
If this theme plays out then it could have the biggest impact on these two pairs:
1, USDJPY: which is traditionally sensitive to changes in US yields, and
2, EURUSD: the currency bloc is at risk of deflation, so the contrast with the US, where prices are picking up, could weigh on this pair.
Conclusion:
If the US inflation/ yield theme picks up this could have a major impact on the market. Expect it to gain traction if we get another strong NFP on Friday. If job growth stays strong, then the Fed may start to focus on prices.
Right now the market is expecting the first rate hike from the Fed in August 2015, but if inflation continues to move higher and the Fed starts to take notice, expectations for a rate hike could be bought forward, with big implications for Treasury yields and the USD.
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