WITH most market participants expecting a rate increase in the US during 2015, this Wednesday’s inflation figure will be very interesting. Markets anticipate that US inflation will show an annual growth of 1.6 per cent, while the reading that excludes food and energy price changes (the “core” measure) is expected to have increased by 1.7 per cent over the same period. The reason this is interesting is that most central banks adjust their short-term interest rates based on the state of inflation readings and the unemployment rate.
For a rate increase to occur, the unemployment rate would ideally be near its long-term neutral level, and many think the US is about to reach this stage over the next few months. When this happens, inflation tends to appear, and the central bank is expected to act. The only time central banks allow inflation to remain at elevated levels is if they see the unemployment rate as too high.
In the US, we can now talk about the unemployment rate reaching its longer-term neutral level, which has increased the likelihood of a rate increase. As a result of this, investors have been buying the US dollar.
Yet from an inflation perspective, it might be too early to bank on this outcome, making this week’s inflation report especially interesting. Will inflation start to creep higher over the next few months, towards the central bank’s target of 2 per cent? If this does happen, the dollar should gain. If the opposite is true, expectations of an early rate rise may crumble.
Alejandro Zambrano is a currency strategy analyst at DailyFX.com. He leads a monthly educational seminar for FXCM live clients at http://bit.ly/PremiumEDU
You can follow him on Twitter @AlexFX00