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If the chart below from Westpac Bank is anything to go by, headline inflation in the US could be about to fall off a cliff.

It shows US West Texas Intermediate (WTI) crude prices overlaid against US PCE inflation going back to the start of the decade. Both are expressed in six-month annualised percentage terms, with the WTI advanced by two months.

There’s little doubt that where crude prices move, headline inflation tends to follow.

While the US Federal Reserve’s favored inflation measure is the core PCE deflator — which removes the impact of food and energy price movements to provide a better overall guide of underlying inflation pressures — at a time when markets are hyper-sensitive towards the outlook for US interest rates, Westpac says an abrupt decline in the headline PCE could keep the US dollar under pressure near-term.

“The plunge in energy prices will take a bite out of US headline inflation print, while the December 19 FOMC meeting could see some of the more hawkish dots in the Fed’s projections ease back around a likely unchanged median,” says Richard Franulovich, Head of FX Strategy at Westpac.

“That likely keeps the US dollar defensive near-term before medium term strength resumes in 2019.”

“The US dollar index weakness should not extend much beyond 94-95.”

The US dollar index, or DXY, currently trades at 96.8.

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