The astonishing increase in US inflation this year has focused market attention.  Is the Federal Reserve correct that the burst is temporary, a product of shortages and supply dislocations? Or has the economic impact of the pandemic lockdowns been deeper and more permanent than anyone realizes? Join FXStreet senior analysts, Valeria Bednarik, Yohay Elam and Joseph Trevisani for a thorough examination of the raging debate over inflation.

Yohay Elam: Inflation continues rising in the US – the headline Consumer Price Index hit 5.4% YoY and Core CPI reached 4.5%, both above expectations. The US dollar experienced a knee-jerk upward move but then lost some ground. Inflation matters more to markets than in the past, but the effect seems limited.

Joseph Trevisani: Yes the dollar rose on CPI on Tues then fell back on Wednesday as Chairman Powell repeated the Fed's temporary mantra.

Yohay Elam: What matters is not data, but what all-powerful Powell says about it.

Valeria Bednarik: Central bankers are scared to retrieve monetary support too early. Past effects of such action are still fresh in their memories.

Yohay Elam: Indeed, the Fed overestimated inflation so many times in the past.

Valeria Bednarik: Not just the Fed. Anyway! as Joseph called it, the "temporary mantra" will persists until it is denied by reality. That is multiple in-line months of persistently high inflation. At least a full quarter of data.

Joseph Trevisani: I view the Fed's past history through its bureaucratic mandates. After the financial crisis the Fed wanted inflation at its 2% it continually predicted that would be so. Now it wants inflation at  2%... So it is again predicting the same...

Valeria Bednarik: But wait! Where was inflation before the pandemic? wasn't there? And what did central bankers change? nothing in escense. Maybe is time to look somewhere else for trading hints.

Joseph Trevisani: Headline CPI was 2.3% in February...

Valeria Bednarik: Exactly.

Yohay Elam: Prices fell sharply in the spring of last year, resulting in base effects that were anticipated early in the year. The bigger deal is the monthly increase.

Joseph Trevisani: I have no doubt some or most of the sharp gains recently are due to that effect. It is why the Fed adopted inflation-averaging last September. The base effect was very predictable. Exactly, the base effect has little to do with a 0.9% June increase.

Valeria Bednarik: Yeah, and the monthly increase can't be attributed to a "return to normal" as US economic activity contracted, but far less than those of its major rivals.

Yohay Elam: Indeed, Powell is talking about makes sense. The rapid reopening meant strong demand coming at once, causing supply bottlenecks. The biggest jumps are reopening-related:

  • Car rental 87.7% (y/y change)
  • Used cars 45.2%
  • Gas 45.1%
  • Laundry machines 29.4%
  • Airfare 24.6%
  • Moving 17.3%
  • Hotels 16.9%

Valeria Bednarik: But not that there were too many lockdows in the US. Indeed, the services sector, mostly linked to hospitality suffered the most.

Joseph Trevisani: All true, and don't forget wages and bonuses.

Yohay Elam: And it could suffer again if Delta spreads rapidly and people skip going out and staying at hotels. Renting cars or buying used ones as well.

Joseph Trevisani: The problem is expectations.  Firms have has little pricing power for many years. They now have a prefect excuse to take some back.

Yohay Elam: The bigger questions are not about the current bounce, but if firms indeed change their behavior. In two ways: 

  1. Persistently passing costs to consumers. 
  2. If they are willing to pay higher wages.

Valeria Bednarik: May have changed it, but the changes won't last. The world is eager to "return to normal"  In one year, things will be back to where they were economies won't. Economies will need much more time to recover.

Joseph Trevisani: Yes, and there are dislocations in supply chains that will take years to correct. For instance Intel is building a chip plant in Arizona, but it will be a few years before it is online.

Yohay Elam: Indeed, the chip shortage is the single biggest issue that could make inflation more persistent.

Joseph Trevisani: These are the known unknows, in the phrase of Donald Rumsfeld, who died recently.

Yohay Elam: Because of what you said and because chips are everywhere.

Joseph Trevisani: But I suspect there are unknown unknowns out there in the global economy as well.

Yohay Elam: Rumsfeld's legacy lives on.

Joseph Trevisani: For instance, how much disruption to globalization is permanent.  Will firms choose to locate nationally, especially manufacturing. China has done itself much harm I think with its Covid response.

Valeria Bednarik: Yups, that's the key. Disruption to globalization. Relocations are the reason while economies will take longer to recover, and of course, it will be uneven.

Joseph Trevisani: Rare earth metals are another sign of change. The US largely stopped mining them over the past decade for environmental reasons, but that ceded the world supply to China. Exactly, and that means higher inflation  for longer.

Yohay Elam: Deglobalization is the biggest long-term driver of inflation, as globalization depressed prices in the past two decades.

Valeria Bednarik: So, we are saying that Powell is wrong, right? That inflationary pressures won't be temporary?

Yohay Elam: Not so fast... However, China is not stimulating its economy at the wake of the covid crisis, very different from the reaction in 2008. For me, there is no persistent inflation without Chinese stimulus. In the medium term...

Joseph Trevisani: No exactly, the Fed's two mandates, full employment and price stability are, in monetary policy terms, contradictory.

Valeria Bednarik: Ok, so we don't see inflation persistently high. What are then the implications for the dollar?

Yohay Elam: There is growing chorus at the Fed that wants to taper, so inflation is still dollar positive.

Joseph Trevisani: The Yuan is stronger, that helps with Chinese domestic inflation.

Yohay Elam: but if Powell refrains from declaring something in Jackson Hole, I think the greenback could tumble.

Valeria Bednarik: Agreed.

Joseph Trevisani: Immediate dollar implications turn on the Fed.

Yohay Elam: There is a quote associated with Stalin: it does not matter who votes, but who counts the votes. Something similar applies to inflation and the dollar. What matters is what the Fed says about it.

Valeria Bednarik: Nice one!

Joseph Trevisani: Yes, but not always.  In 2007 Treasury rates turned south before the Fed cut rates. Let posit US inflation above 4% for the rest of the year. How much pressure would that build on the Fed?

Yohay Elam: That would build pressure on the Fed and the dollar. Year-end is critical. Vice-Chair Richard Clarida said that if inflation remains high at year-end, it would not be transitory anymore. And if so, the dollar would be a big winner.

Joseph Trevisani: Agreed. And then there is politics. Inflation is very very damaging to the political party seen as responsible. In this case the Democrats, who already appear to be facing a difficult election sent year.

Valeria Bednarik: Indeed. Six months is no longer transitory.

Joseph Trevisani: The Fed has not defined its terms, for transitory or inflation-averaging.

Yohay Elam: I am still betting on a cooldown in inflation, as bottlenecks are gradually resolved. And as the Delta variant erodes some of the growth and price pressures

Joseph Trevisani: The Delta could also worsen supply problems, with new closures and worker reluctance. At best I think its a wash.  In fact, I don't think anyone has a good handle on the current inflation, the Fed or anyone else. It's another novel economic situation.

Yohay Elam: Novel coronavirus, novel economic situation

Joseph Trevisani: As in the US labor market, 9.2 million unfilled jobs and Washington pouring unprecedented debt financed stimulus into the economy. It is a rather classic monetary inflation set-up.

Yohay Elam: Unfilled jobs, like supply bottlenecks, will eventually be resolved. I think Delta will have more impact on the services sector than other ones. This is what is happening in the UK, where more people are vaccinated. It is ahead of the US also with Delta

Joseph Trevisani: Yes but they are going ahead with full reopening aren't they?

Valeria Bednarik: Delta, Delta plus, whatever, the people won't take much more of this situation. The UK government will return to "normal" on Monday, regardless record cases. The world has to learn to live alongside covid.

Yohay Elam: In the UK, they have a better chance of absorbing it, as vaccination levels are high.

Joseph Trevisani: Yes and hospitalization and fatality rates, so far, are still very low, much lower with the commensurate case load last year.

Valeria Bednarik: the rate is good, but not that different from the US one

Yohay Elam: Indeed, not a huge difference. And in the US there is higher tolerance to death, so perhaps Delta will not have a significant impact.

Joseph Trevisani: I'm not sure we have a higher tolerance  for death, but we do tend to balance with other considerations, economic and personal freedom.

Yohay Elam: Returning to inflation and mentioning the UK, CPI hit 2.5% YoY in June, higher than expected.

Joseph Trevisani: Money is fungible. One reason Canada can cut its stimulus, paltry at any rate, is because the US is pouring money out of DC.

Yohay Elam: And here in Europe, stimulus has been paltry in response to the 2008 crisis, and it caused a second recession in 2011. Hopefully some of the lessons have been learned. The age of austerity is over.

Joseph Trevisani: True, but I doubt it. Europe has now structure for EU wide stimulus. no structure.

Yohay Elam: The EU raised money in markets for euro bonds a few weeks ago, part of the NG EU project. That is a structure and a change. In my opinion, insufficient. But that's far more than beforehand.

Joseph Trevisani: Inflation certainly looks to be the economic topic de jour, for the next six months at least.

Yohay Elam: And the uneven nature of it could cause fluctuations in currencies. Core CPI is 0.9% in the eurozone, 2.3% in the UK, 4.5% in the US

Joseph Trevisani: The ECB is not a government. It cannot print money. In those figures you have the story of fiscal stimulus.

Yohay Elam: In a global world, you would expect things to even out over time.

Joseph Trevisani: The key being time, but less so than theory suggests.

Yohay Elam: I think that America's super-strong growth is helping lift Europe a bit and inflation could eventually rise also here. Perhaps in 2022. That would be euro-positive.

Joseph Trevisani: Perhaps, but the dollar would gain first.  Of course that gets us back to the Fed, and its, what is fast becoming stubbornness on inflation.  It not that a minor rate increase, or permission for the Treasury market to raise yields, would have much practical effect on prices, but it would impact inflation expectatin. The Fed has painted itself into a corner on employment and inflation. I dont think the governors ever expected there to be 9.2 million unfilled JOLTS jobs.

Yohay Elam: Similar to supply bottlenecks, the dislocation should decrease with time. June's super-strong NFP, 850,000, means JOLTs have likely dropped last month. And I think this trend of rising employment and falling job openings will continue. The Fed sees 6.8 million Americans who still haven't returned to work after the pandemic. They have already sent a signal about tapering in June, without causing a taper-tantrum. So far, so good for the Fed's communication and management.

Joseph Trevisani: I'm going with the Treasury market on tapering, its not really in the picture yet.

Yohay Elam: When do you think the Fed begins tapering? Or announces it? My bet is that Powell refrains from a taper hint at Jackson Hole.

Valeria Bednarik: I would say that he will surprise us by hinting at easing well before year-end.

Joseph Trevisani: We don't get the June JOLTS figure until August 9.    I am changing my view on that, I think the discussion Wyoming will be general, not specific. No suggestion on dates or amounts. If you are right Val, that will send the dollar much higher. Treasury yields also.

Valeria Bednarik: yups that's what I expect.

Yohay Elam: I'm betting on a stock-supporting Fed.

Joseph Trevisani: I had though so too, now I'm not so sure. Powell has staked out a very strong employment mandate.

Valeria Bednarik: So, Dollar is King, but its crown is not yet shinning.

Yohay Elam: I think it can shine, but as a safe-haven due to Delta, and only for a short time.

Joseph Trevisani: Yes, and the dollar has been very resilient.  Here I disagree, I dont think Delta will have much impact and I don't think the re is a safety trade.

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