How will central banks react to rising inflation?

Amid rising inflation…

With inflation data continuing to surprise positively in recent days the coming week will be interesting in terms of showing how central banks are likely to respond to it. US consumer and producer prices were both stronger than expected in January, rising by 0.5% and 0.4% respectively on a headline basis, and by 0.3% and 0.4% at the core level. These suggest that the pick-up in wage pressures reported earlier are unlikely to be a one-off and that a broad based upturn in prices is already underway. However, with the markets undergoing sharp volatility in response to the latest data there has also been uncertainty about how the Fed will respond to it, with past experience sometimes suggesting a preparedness to hold back from raising interest rates in a falling equity market, the so called ‘Fed put’. However, comments from Fed officials in the past week suggest an intention to continue the process of monetary policy normalization, casting doubt on whether the ‘Fed put’ will continue to operate under new Fed Chair Powell. Powell is due to testify to Congress on February 28 before the House Financial Services Committee in which he will outline his approach. Ahead of this the Fed will release its Monetary Policy Report, due out on Friday 23rd of this week, which will be the basis for Powell’s comments.

The markets await Fed guidance

This will be the first major action coming out of the new Powell Fed, and may reflect a more optimistic mood about growth especially following the tax cuts enacted at the end of last year. Of course the Fed will also be aware of the additional USD300bn of spending that was announced last week, which give a boost to their growth and inflation forecasts. The minutes of the January 30-31 FOMC meeting, the last one to be chaired by Yellen, will also be looked at for changes of nuance although these are unlikely to be groundbreaking, with the focus being on what debate if any there was about the dot plot, and whether the Fed could do more or less than the 3 hikes currently implied.

Weekly currency movement vs USD(%)

Source: Emirates NBD Research

The dollar is likely to reflect the messages conveyed to a certain extent, although a striking feature of the last month has been how little it has responded to firmer bond yields. To the extent that yields rally further it may well be the case that the dollar continues to focus on the concerns that this might represent about inflation and about a rising fiscal deficit, rather than the positives that higher interest rates are usually associated with. Furthermore, the prospect of more trade tariffs being introduced increases existing concerns about protectionism and about the Administration’s attitude towards the dollar, while the intensification of the Muller Inquiry adds another dimension of uncertainty to the White House policy outlook.   

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