US: Higher inflation profile is anticipated - Scotiabank

In view of analysts at Scotiabank, US inflation is probably undergoing transitory headwinds related to past USD strength.

Key Quotes

“As the USD has weakened since spring, a higher inflation profile is anticipated and this should support a return to policy tightening. While the connection between the dollar and inflation is hardly air-tight, large, abrupt swings in the dollar tend to be more correlated with large, abrupt swings in import prices and modest pass-through to CPI. The broad dollar index is now at its lowest since April 2016 and has reversed all of the pre- and post-election rally and then some. A more muted correction in the dollar in early 2016 was followed by a rise in core PCE inflation from about 1.2% y/y to 1.9% y/y with several drivers, the USD among them.” 

“It is important to recall the literature and to note that the Federal Reserve views the currency’s role in this way. Indeed the speech about two years ago by retiring Vice Chairman Stanley Fischer was specifically on the very topic of exchange rate effects on growth and inflation. Fischer stated that Fed models indicate that for every 10% trade weighted appreciation in the dollar, core PCE inflation is reduced by 0.5% in the two quarters following the dollar’s move and the four-quarter effect is to reduce core PCE inflation by about 0.3%. Note that the broad dollar index appreciated by about 9% from the spring of 2016 until early 2017 and has since depreciated by a similar amount.” 

“It is therefore conceivable that much of the deceleration in core PCE inflation from 1.9% at the start of this year to 1.4% as of August was due to the dollar’s prior appreciation. By corollary, dollar depreciation since earlier this year may well have the Fed much closer to its inflation target as soon as 2018H1.”