US Dollar Advances as Consumer Splurge Continues and Fed's PCE Inflation Eyes Target

-US Dollar advances as consumer splurge goes on in June.

-Fed's preferred inflation measure holds 1.9%, close to target.

-Numbers place economy and Dollar on front foot for third-quarter.

© Openwater, Adobe Stock

The US Dollar reversed earlier losses and climbed higher Tuesday after official data showed US consumers opening their wallets to an even greater extent than economists had previously during June, placing the economy on the front foot at the start of the third-quarter. 

Bureau of Economic Analysis data showed US personal consumption expenditures, defined as consumer spending on all items, rose by 0.4% during June and by 0.35 after inflation is taken into account. The former number is down from the 0.5% growth seen in May and in line with the market consensus. 

"Although we already knew that real consumption surged by 4% annualised in the second quarter overall, it provides a decent hand-off to the third quarter. Spending growth is still likely to slow to a more sustainable pace, particularly as the one-time boost from the tax cuts fades. But for now at least, that slowdown looks set to be fairly gradual," says Andrew Hunter, a US economist at Capital Economics. 

Currency markets care about the spending data because it reflects rising and falling demand within the US economy, which has a direct bearing on consumer price inflation and is itself important for questions around interest rates.

The PCE price index, which is the Federal Reserve's preferred measure of US inflation, rose by 0.1% during the month in both headline terms and after volatile items like food and energy goods are removed from the expenditures basket. This leaves the annual pace of PCE inflation sat at 1.9%, which is more or less on the button of the Fed's 2% target. 

"Although the wages and salaries component of the employment cost index, also released today, rose by a modest 0.5% in the second quarter, that was still enough to lift the annual rate up to a 10-year high of 2.8%. With the labour market tightening, stronger wage pressures should continue to feed through into higher inflation over the rest of this year," Hunter adds.

Currency markets care about the price data because inflation has a direct bearing on the interest rate and other monetary policy decisions of the Federal Reserve, and it is changes in rates themselves that are the raison d'être for most moves in exchange rates.

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

The US Dollar index was quoted 0.12% higher at 94.42 following the release after reversing an earlier loss while the Pound-to-Dollar rate was 0.06% lower at 1.3127 and the Euro-to-Dollar rate was 0.01% lower at 1.1705. 

Tuesday's numbers come after official data showed US GDP growth rose at an annualised pace of 4.1% during the three months to the end of June, up sharply from the upwardly-revised 2.2% pace of growth seen at the beginning of the year.

This was the fastest pace of growth seen in any individual quarter for the last four years. Consumer spending and strong export trade growth were the main contributors to the uptick in US growth, although federal and local government spending were also flagged by the Bureau of Economic Analysis as key drivers behind the upturn too.

"Spending growth likely won't be maintained at the Q2 pace; early indications for auto sales and core retail spending in July point to a clear softening," says Ian Shepherdson, chief economist at Pantheon Macroeconomics. "For now the Fed will see nothing much to worry about."

The Federal Reserve has raised interest rates seven times since the end of 2015, taking the Federal Funds rate range to between 1.75% and 2%. Many economists expect it to raise rates so that the top end of that range hits 3.25% around the end of 2019.

Most analysts now agree that superior levels of US economic growth have bolstered the case for the Federal Reserve to keep raising its interest rate, at a time when the interest rate outlook elsewhere in the world has deteriorated, which has incentivised traders into selling other developed world currencies and buying US Dollars.

As a result, the Dollar index converted what was a 4% 2018 loss into a 2.8% gain during the three months to Friday 27, July, after having fallen by 10% in 2017 and dropping another 4% during the first quarter of 2018. Analysts are now divided as ever in their forecasts for where the US Dollar will head next. 

"The FOMC consolidated and updated its statement language in June, which likely means no material changes for August. The opening paragraph should cite strong recent GDP and job growth, with inflation returning to target. This near-term optimism is already fully priced into market expectations for a September rate hike," says Mark McCormick, North American head of FX strategy at TD Securities. 

The Federal Reserve will announce its latest interest rate decision at 19:00 London time Wednesday, although economists are unanimous in forecasting that it hold its interest rate steady this week, favouring the September and December meetings for its next changes in policy as these are accompanied by a press conference. 

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