Only the Dollar Knows Where Inflation Goes

March figures for the Federal Reserve’s preferred inflation indicator, the Personal Consumption Expenditures Price Index excluding food and energy, showed an increase in the 12-month rate from 1.6% in February to 1.9% in March. Are we reaching the Fed’s long-standing goal of 2.0% for this “core” figure? Will there be a “symmetrical” overshoot of the target? Is inflation taking off after years of stimulative monetary policies? Has the Phillips curve been resuscitated from the dead?

Only the dollar knows.

An apparent factor frequently cited for the difference in 12-month numbers between February and March was getting past the low monthly reading for March 2017 of negative 1.8% (monthly figures are annualized) for core PCE prices, which was driven largely by a decline in cell phone service prices. This statistical quirk need not imply sustained higher inflation though. While the March 2017 figure was 2.9% below the five-year median monthly rate for March of 1.1%, October 2017’s monthly core PCE reading was 1.5% and December 2017’s figure was 0.6% above those months’ five-year medians. In the end, statistical quirks are likely to be offset and unlikely to drive inflation’s direction. Chart 1 compares core PCE data for 2017 and 2018 with longer-term figures highlighting the statistical quirks.

One thing that has significant impact on inflation is the foreign exchange value of the dollar. Just as inflation is the change in a price level between today and the past, understanding the dollar’s impact is facilitated by looking at changes in the dollar’s current value compared with its recent past average.

Since many global commodities are priced in dollars, when the dollar’s value changes, the impact on global supply and demand often produces a change in the commodity’s dollar pricing, which then affects inflation.

Oil markets are known for being especially sensitive to the dollar’s value. Comparing the price of oil, measured by its West Texas Intermediate benchmark, with the value of the dollar, measured by the recent average of its trade-weighted value compared with its current value, produces a close correspondence. The dollar’s value alone explains nearly 40% of oil price fluctuations, as represented in Chart 2.

Of course, other factors affect oil’s price - global economic conditions, international politics, and, particularly, OPEC policies, which add additional noise to the relationship between the dollar and oil.

A cleaner relationship is found between the dollar and industrial metals prices, as measured by the Producer Price sub-index. As depicted in Chart 3, the dollar’s value explains over 50% of the variability of metals prices.

Naturally with such a strong effect upon commodity prices, the dollar’s value will be reflected in broader prices measured by the PCE index. Headline PCE inflation, including food and energy, with its large commodities component, is especially sensitive to the value of the dollar. Chart 4 illustrates how the exchange value of the dollar explains over 40% of headline PCE price variability.

While core PCE prices show major sensitivity to the dollar’s value, headline PCE prices, with smaller commodity exposure, are less sensitive, one of the reasons the Federal Reserve prefers them as more stable indicators of inflation trends. Nevertheless, the dollar has a significant effect on core prices, explaining over 25% of their variability, as illustrated in Chart 5.

If one can forecast the near-term track of the dollar, they may be able to know inflation’s direction. (Anyone accurately forecasting the dollar, please inform the author!) As of May 7, the Federal Reserve’s trade-weighted dollar index against major currencies stood at 88.21. Should it revert to its average for the last three years of 90.78, recent upwards inflation pressure should reverse on headline measures and likely on core measures as well.

Douglas Carr is President of Carr Capital Co.

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