ISM Manufacturing PMI: Dollar to dominate in duel between inflation and employment components

When will inflation reach its peak? That question has returned to the forefront now that the recession discussion has been relegated to politics. Markets only care about the Federal Reserve's next moves -- and every piece of data counts. Here is why I think the ISM Manufacturing Purchasing Managers' Index is set to boost the dollar. 

This forward-looking business survey used to be a critical leading indicator for Nonfarm Payrolls. It remains significant, and any further drop in this sub-component would be worrying, pointing a downturn in hiring in the industrial sector. Back in June, it extended its drop under 50, the threshold separating expansion and contraction.

Source: FXStreet

If the employment component nears 40, investors would see the labor market as cooling fast, implying fewer rate hikes would be needed from the Fed. However, the labor market plays second fiddle to inflation. 

The Fed is fully focused on its price stability mandate, much more than employment. By pointing to the Employment Cost Index as a critical figure, Fed Chair Jerome Powell hinted he would like to see further cooling. A lower shortage of workers would help bring inflation down. 

Therefore, the Prices Paid component in the ISM Manufacturing PMI is even more important and remains sky high. Despite dropping to 78.5 points in June, the indicator is at extremely high levels -- and projected to climb back to 81. 

I have no reason to believe it will beat nor miss expectations, but I can say that even if it only holds above 75, it would indicate that price pressures are elevated. 

Moreover, Americans have been shifting back from buying consumer goods such as Pelotons and cookware to purchasing experiences such as flights or restaurants. Walmart is stuck with big inventories while airport queues are lengthening. That pendulum swing back from goods to services should hurt the manufacturing sector -- and also lower prices. If inflation in this sector remains well above historic norms, it would indicate that price pressures for services are even higher.

While the Gross Domestic Product (GDP) is negative, price pressures remain elevated, as seen by the better-than-expected Employment Cost Index (ECI) at 1.3%, and the Core Personal Consumption Expenditure (Core PCE) at 4.8%. Both figures sent the dollar up, as they represent inflation. I see this as a sign of what is important. 

All in all, if the inflation component remains high, it would likely push the dollar up. Only a substantial drop in the inflation component and a weak employment one would send the dollar down. 

Final thoughts

The ISM Manufacturing PMI will be eyed for signs that inflation is falling, but the chances of a substantial improvement are low. In this scenario, the dollar has room to rise.