US inflation - the hidden metrics to look for and how to trade it

Market Analysis /
13 Feb 2019

The start of the year has been defined to at least some extent by a series of dovish calls from the Federal Reserve. Slowing US inflation and fears over the global economic outlook – caused in no small part by aggressive US trade policies – have cast a shadow over domestic growth prospects. The Fed is therefore pushing a message of keeping interest rates unchanged in a bid to encourage consumer spending and in turn bolster the economy.

Traditionally, such a narrative would be seen as negative for the US Dollar, but a series of extraordinary circumstances are prevailing right now and this has pushed the DXY Dollar Index – a measure of the greenback versus six other major trading currencies – close to fresh highs for the year. A key risk here appears to be that inflation will soon start to take off once again, forcing the Federal Reserve to resume its hawkish narrative, driving the dollar higher as a result. So, bearing in mind that Central Banks are supposed to envisage inflationary pressures before they materialise,  what are the major drivers to look for as this narrative unfolds, and how can they be traded?

  • Rising trade tariffs to push up import prices

Failure for the US and China to reach a compromise over trade by the March 1st deadline (or alternatively for the deadline to be pushed back) could lead to renewed inflationary pressures emerging. As has been seen since the tariffs were first rolled out, the strengthening US dollar and a lack of flexibility amongst consumers has offered importers a degree of protection against rising prices. Assuming there’s no change in the underlying situation, this would have the potential to drive inflation higher, meaning that the dollar may find fresh support.

  • Renewed Federal Reserve stimulus

There’s a measure called the St Louis Fed’s Adjusted Monetary Base. The number is printed each fortnight and shows all the money held on deposit by financial institutions. Following the credit crisis, Fed stimulus measures saw this figure increase dramatically:

There’s some concern that as this figure declines, it illustrates a movement of capital out of the banks and into the real economy. A sharp move lower here could therefore be seen as a warning sign that consumers will be spending more – the decline in this reading from October 2015 to December 2016 coincided with an uptick in US inflation from 0% to almost 3%. A move of this magnitude from the current 1.9% would certainly necessitate a reaction from the Fed.

  • Change in fiscal policy

Donald Trump’s generous tax breaks were seen as a calculated gamble to try and bolster economic growth in the longer term, but at least so far the impact is looking to have been rather short lived. However, with the 2022 election already coming into focus, could another round of incentives be on the table? With the Republican party weakened in Washington, that might not be an easy feat to achieve, but a bipartisan consensus to fund infrastructure projects in the US could lead to further amendments to taxation and spending policies. Depending on how this maps out, the benefit could well pave the way to higher inflation.

The Fed is targeted with keeping inflation at 2% and the core tool for enabling this is monetary policy, principally adjusting the rate of interest. There’s plenty of reasons to see why the Fed’s idea of sitting tight and doing nothing for most of the year ahead won’t work, but with their responsibility being to second guess the market, it’s the early indicators of inflation – rather than inflation itself – which have the potential to send the real signals. Higher US interest rates should almost inevitably lead to a stronger US Dollar.

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