Dollar Dominance Could be Questioned by Expectations for Cooling Inflation Pressures

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The Dollar's long-term uptrend will likely could cool into year-end amidst expectations for a cooling of inflationary pressures over coming weeks.

Official data revealed that U.S. inflation pressures remained elevated during October, although recent developments in oil markets mean the outlook for price growth is cooling.

U.S. inflation rose at an annualised pace of 2.5% during October, up from 2.3% previously but in line with the market consensus. 

Core inflation, which removes volatile food and energy items from the goods basket and so is seen as a more accurate representation of domestically generated inflation pressure, rose by 2.1% on an annual basis.

October's core inflation is below the 2.2% rate seen in September and also beneath the market consensus for an unchanged reading. 

"Core price pressures rose 2.1% y/y, a hair below expectations, with the slight miss attributable to slower shelter price growth than was observed a few months ago. A reversal in used car price weakness materialized as expected, likely helped by vehicle replacement following hurricane Florence, but that wasn't enough," says Katherine Judge, an economist at CIBC Capital Markets. 

The miss against expectations for the core number comes at a time when the outlook for overall inflation pressures is cooling rapidly. Consumer prices have been boosted in 2018 by what was once a 16% increase in the oil price.

However, with WTI crude oil futures prices falling 20% from $71 per barrell in October to just $56 in November, U.S. oil is now trading at a -5% 2018 loss. As a result, inflation is set to decline going forward.

"Next month’s headline CPI will be depressed by falling gasoline prices, but the near-term impact on the core will be minimal; airline fares will decline but they are a very small component," says Ian Shepherdson, chief U.S. economist at Pantheon Macroeconomics. 

Markets care about inflation because it has implications for interest rates, which are themselves the predominant driver of exchange rates.

Changes in interest rates are only normally made in response to movements in inflation but impact currencies because of the push and pull influence they have on capital flows and their allure for short-term speculators.

The Dollar is the best-performing G10 of 2018 thanks to an economy that is outperforming its global peers and a central bank that is hiking rates while others are doing so only gradually or merely just sitting on unchanged interest rates.

Above: Dollar is 2018's best performing currency thanks largely to expectations for elevated levels of inflation. Should these expectations fade we could see this outperformance diminish.

The U.S. Dollar index was quoted 0.08% lower at 96.87 Wednesday, leaving it up by 4.9% for the 2018 year.

The Pound-to-Dollar rate was 0.18% lower at 1.2991 and the Euro-to-Dollar rate was up 0.23% at 1.1336.

"The rebound in headline CPI inflation to 2.5% in October, from 2.3%, was mostly driven by a rise in gasoline prices that will be more than reversed over the next couple of months. The rest of the report supports our view that underlying inflation is unlikely to rise much further from here," says Andrew Hunter, an economist at Capital Economics, in a note to clients.

The inflation data matters because of what it could mean for the Federal Reserve (Fed) interest rate outlook.

The Fed has raised U.S. interest rates eight times since the end of 2015, leaving the top end of the Federal Funds rate range at 2.25%. 

Fed officials suggested in September the bank will raise its interest rate so the top end of the above range reaches 3.25% some time in 2019, and that rates could rise further in 2020, to 3.5%.

Most of these anticipated moves have already been taken to the bank by the market so for the Dollar to benefit from anything more that the Fed might do in the future, the inflation and growth outlook would need to become hot enough to prompt the market to price in even more rate rises. 

"The Fed is still likely to continue hiking interest rates once a quarter in the near term, with the next move coming in December. But with little sign that a more marked acceleration in inflation lies ahead, Fed officials won’t hesitate to back away from further tightening if economic growth slows," Hunter says. 

Wednesday's data shows that price pressures are no longer mounting in the U.S. economy which, if anything, may place a question mark over numerous future rate hikes already hinted at by the Federal Reserve.

And growing numbers of economists are warning of a possible slowdown in U.S. economic growth arriving some time in 2019. 

"With the fiscal boost now fading and rising interest rates starting to take their toll on rate-sensitive activity, we expect that to happen by the middle of next year, sooner than most currently anticipate," Hunter adds.

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