USD: Markets Expect A 75 Rate Hike From Fed. Inflation Data Could Throw Light On Further Moves Of Federal Reserve

According to ING, US Producer Price Index may mean that inflation could decrease earlier

Tomorrow is likely to be one of the most important days for the markets this week, because we get some crucial data ahead of the FOMC meeting next week. To make matters more interesting, the Fed is already in its blackout period. Meaning officials are likely to not respond to the data, and provide some context on how it could affect the interest rate decision.

The market is pricing in a 75bps hike at the next meeting, based on expectations that inflation will remain high. But this opens the question of what could happen with the data that might change those expectations? Can the Fed be dissuaded from a "triple hike"? 

US Dollar (USD)

What's driving the moves

The Fed is looking to restore what it calls "credibility", in order to "anchor" inflation expectations. This is because the economic theory that the Fed is following argues that prices fluctuate primarily based on whether market makers think prices will go up. It's the job of monetary policy, therefore, to "anchor" those expectations at a certain level. How? By ensuring that market makers believe that the Fed will do what it takes to get inflation back to that level. That belief is called the "credibility" of the bank. Which is why there is such a strong push by the Fed at the moment to communicate that interest rates are going to keep rising.

But the purpose is to get inflation to go down. So, if inflation has peaked, then it could be understood that inflation expectations are starting to get "anchored" and the Fed has retained its "credibility". Therefore, further aggressive hikes might not be needed. Since bond values are pricing in where the rates will be in a few months, when the Fed will start slowing the pace is the key to markets. If inflation comes down, it might signal that interest rates won't rise as fast, which could continue to weaken the dollar.

What's in the data

The headline number is what's going to get most of the media coverage, since that's what affects consumers most directly. Annualized August CPI Change is expected to slow down to 8.1% compared to 8.5% prior. That would be the second consecutive months of declines, and might start providing a more convincing case that inflation has peaked.

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But the Fed cares more about the core inflation rate, which doesn't consider the variation in the cost of food and fuel. We have to remember that food prices have continued to rise, but fuel prices have been declining since June. WTI Crude, the benchmark for US fuel prices, fell below $90/bbl last month, continuing a lower trend due to slowing demand.

Potential Fed reaction

Core August annualized CPI is forecast to accelerate to 6.1% from 5.9% prior. This would bring it back up to a rate not seen since May, and be more than three times the Fed's target. With crude prices going down, a rise in core rate could imply a more systemic price problem. That would likely make the Fed even more eager to restore "credibility" by hiking rates.

If headline inflation falls, but core inflation increases, the Fed is likely to stick to its hiking path. But if core inflation were to unexpectedly come in below 5.9%, it would imply that the trend remains downwards since April, and could lead to a reevaluation of how many hikes we can expect by the end of the year.

According to ING, US Producer Price Index may mean that inflation could decrease earlier

Jing Ren

Jing-Ren has extensive experience in currency and commodities trading. He began his career in metal sales and trading at Societe Generale in London. Later on he worked as a senior analyst within the FX brokerage industry where he developed strategies in trading and risk management. With solid understanding of market dynamics he founded Wensfer to offer research and asset management services.