Inflation update the last chance for a Fed hike next week
- The widely publicised CPI figure is the missing piece of the puzzle for the Fed
- Surveys of US inflation expectations are “anchored” around 2%
- A CPI surprise would be required for the Fed to step up to the plate next week
Yesterday’s retail sales and industrial production numbers out of the US came in below expectations, further dampening the prospects of a rate hike by the Federal Reserve next week. But the most important piece of data comes out today: the Consumer Price Index.
Inflation is the missing piece of the jigsaw as far as the Fed is concerned and for months they have been telling us that’s because of the “transitory” effect of earlier declines in energy prices. That argument is starting to wear a bit thin and analysts will be looking for evidence in today’s numbers that the Fed isn’t engaged in wishful thinking.
After yesterday’s data December Fed funds futures suggest the chance of a rate hike by year end has moved back under 50% (Click to enlarge)
Fed funds chart
The chart below shows headline CPI is currently running at 0.8% year-on-year and the core rate at 2.2%. Analysts expect both will have increased by 0.1% after today’s update.
On the face of it, a core CPI number holding above 2% for the last few months should be sufficient for the Fed to declare “Mission Accomplished” on inflation.
CPI 2000-2016 chart
But while most countries use the CPI as their inflation benchmark, the Fed in its wisdom decided a few years ago that “inflation at a rate of 2%, as measured by the annual change in the price index for personal consumption expenditures (PCE) is the most consistent over the long run with the Federal Reserve’s statutory mandate”.
That shouldn’t have been a problem because historically the CPI and PCE have tracked each other closely. But, as the following chart shows, shortly after the Fed adopted the PCE as its benchmark, the indices began to diverge and a large gap has opened up (mainly because items such as housing and medical costs have different weightings).
Fortunately for the Fed, the CPI measure is the most widely publicised and this explains why surveys of inflation expectations are “anchored” around 2%.
CPI-PCE 2000-2016 chart
A further complication is that, while the core numbers might be the best guide to inflation over the medium term, they exclude “volatile” items such as food and energy prices, and the Fed’s mandate is to achieve 2% inflation in “overall consumer prices”. This all-items measure is referred to as the “headline rate”. In the twelve months to July headline inflation as measured by both the CPI and PCE was about 0.8%, well under the core rates because of the impact of oil price falls earlier in the period. The Fed thinks this is a “transitory” effect and that the headline rate and core rates will merge as those oil price declines drop out of the annual calculation.
We won’t get the PCE inflation numbers until the end of the month but today’s CPI update will be a leading indicator for the FOMC as they ponder the prospects for inflation on Wednesday.
In addition the the FOMC, the Bank of Japan and Reserve Bank of New Zealand will issue monetary policy statements next week. The chart shown below shows forward rate curves based on futures pricing and the Overnight Index Swap (OIS) market. Japan’s is not shown but it closely matches that of the European Union.
The US curve has been flattening out all year but is still the only one with an upward slope. In contrast rate cuts in the next few months are built into the others. These forward curves, rather than current rate differentials, will be the major influence on USD crosses leading up to the new year.
Source: Bank of New Zealand
It’s not often we get surprises in CPI updates these days but that’s what would be required for the Fed to step up to the plate next week. A surprise in today’s numbers would be the monthly headline and core rates increasing by 0.2% or more. Unlikely, but stranger things have happened.
– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.