US CPI Preview: Hard core inflation to propel dollar to new highs, and two other scenarios

Is that the peak over there? That question for mountain climbers resonates with investors, who are eager to see where inflation reaches its limits. The longer the fog continues, the longer the bloodbath in markets. For the dollar, it is a boon.

The greenback's next significant moves hinge on the Core Consumer Price Index (Core CPI) which is projected to have risen by 0.4% in April and 0.3% in March. That surprisingly low figure in the previous month fuels hopes for a lower read this time and a light at the end of the tunnel for stock traders. I will argue that this light is only a fleeting glimpse.

Why it matters

First, why is Core CPI more important than headline CPI? While Americans undoubtedly consume gasoline and food, these items' prices are volatile and the Federal Reserve has little impact on them. These are mostly supply-side issues driven by global forces such as Russia's war in Ukraine and OPEC+ petrol output. The dollar moves to the tune of the Fed's interest rates.

What the Fed can significantly impact is demand – if it raises interest rates, consumers are motivated to save money rather than take loans to make big purchases. It has vowed to bring inflation down with higher borrowing costs – and it can afford to do so. The latest jobs report showed a tight labor market. Employment has room to climb down from the highs. 

Why are monthly figures more important than yearly ones in the upcoming release? In the upcoming annual calculation, April 2021 will be omitted to include changes seen in April 2022 – and that month was different.

Stimulus bump:

Source: FXStreet

At this time last year, inflation jumped due to the one-off effects of the rapid reopening of the economy and stimulus checks, while April this year was already a normal month. Core CPI leaped by 0.9% in April 2021 and no economist expects a similar rise this time. That is why annual figures are set to fall significantly, putting the focus on monthly data. 

Expectations and reactions

1) Core CPI at 0.4% as expected: As I have mentioned, estimates stand at a 0.4% increase in Core CPI MoM and every tenth of a percent matters. This is the most likely scenario and is a dollar-positive one. The 0.4% estimate comes after economists had missed last month's figure by 0.2%, so they are likely more cautious this time around. 

On an annualized basis, it would reflect a rise of almost 5%, substantially above the Fed's 2% target. It would also be higher than the 0.3% level recorded in March and would label that figure as a one-off slow down in price rises. In other words, peak inflation would remain a mystery.

At the time of writing, bond markets foresee a 95.9% chance of a 50 bps hike. That may change.

Source: FXStreet

For the dollar, it would extend the greenback's rise – give it a green light to move higher after the pause in recent days. 

This scenario has a high probability.

2) Core CPI at 0.3%, below expectations: This scenario is based on the fact that persistently high energy prices have left less money in Americans' pockets for other goods and services, alleviating price pressures. It is also backed by the slowdown in monthly Average Hourly Earnings for April– 0.3% vs. 0.4% expected – but these monthly changes are prone to revisions. March's wage figure was revised up. 

Nevertheless, if America records two consecutive months of 0.3% underlying inflation rises, it would strengthen the Fed's conviction of raising rates by only 50 bps in June, lowering the chances of a bigger 75 bps increase. That would hurt the dollar and this scenario has a medium probability. 

An even bigger downfall with 0.2% would already put "peak inflation" high on the agenda, but the chances are low.

3) Core CPI at 0.5%, above expectations: This figure beat estimates in three of the past six releases, so an upside surprise cannot be ruled out. I will stress again, that it is only a tenth of a percentage point, but one that can make a big difference in the dollar's direction. 

Latest Core CPI outcomes:

Source: FXStreet

Such an outcome could represent a catch-up in price rises after the relative slowdown or could be boosted by one-off factors. For the dollar, it would represent a considerable shot in the arm, propelling it higher. Bond vigilantes would begin circling around a 75 bps hike once again. 

This scenario has a lower probability. 

Final thoughts

The Fed is focused on inflation, not employment, and every tick in underlying prices would have an outsized impact on markets. The base case scenario is of ongoing high inflation – an ongoing hawkish approach by the world's most powerful central bank – and a driver of further dollar gains.