Struggling US Dollar Could Find Salvation in Upcoming Inflation Data Release

On Wednesday the 13th of April a monthly comparison of Core CPI is forecast to show prices rose 0.2% in March, down from the 0.3% in the previous month.

Inflation data will form the data highlight in the United States for the week ahead and it is whether this forecast is met, or perhaps more importantly, how it is missed, that will determine whether the dollar sinks or rises.

The release of inflation figures comes at a time of protracted dollar weakness with the US dollar Trade-Weighted Index falling roughly 2.5% in March – a second straight monthly decline.

If Thursday’s data shows inflation is running ahead of expectations we would expect markets to take this as a sign that the Federal Reserve may consider raising interest rates, perhaps twice, in 2016.

This would certainly cast a favourable light on the Greenback.

The US Federal Reserve, like most major central banks, targets inflation at 2% as this is deemed an indicator of a healthy economy that is growing yet not facing dangerous price growth.

The targeting of ‘optimal’ inflation requires the Federal Reserve to move the levers on interest rates accordingly; when inflation is rising ahead of expectations and appears likely to overshoot the target there is a requirement for higher interest rates to quell price rises.

The by-product of higher interest rates is a higher US dollar as vast sums of international money will pour into the country as investor seek higher yield.

Indeed, the promise of higher interest rates in the US has been the bedrock of the dollar’s multi-year rally.

There are of course a multitude of other considerations for the Fed to balance, employment being one of them. But higher-than-expected inflation would certainly catch the markets attention.

Chance for an Upside Surprise

Markets are expecting a 0.2% rise in prices; a figure that shows the US, like much of the developed world, is teetering on the brink of deflation.

The drag from energy prices is still significant, having been in decline for three consecutive months and in negative YoY territory since July 2014.

However, crude oil prices in March rebounded to near $40/barrel before settling just below that level at the end of the month.

“Despite heightened uncertainty, we expect that oil prices will at least remain relatively stable around current levels over the next quarter, reducing the drag on headline inflation,” says Kim Chase, an analyst with BBVA Research.

BBVA reckon core prices are likely to remain below the Fed’s target throughout the next year, with our 12 month probability pointing to about a 70% chance that core CPI hovers between 1.5% and 2.0%.

“However, given the positive price movement seen in 1Q16 thus far, there is an increasing bias towards the upside and a faster rise toward the target by 2018,” says Chase.

If Chase is right, and inflation does beat expectations we could well see the dollar rally.