The Fed expressed that it is planning to tighten monetary policy in the coming years even if inflation continues to undershoot its target. However, a surprising rise in the core PCE index on Friday might raise the odds of further rate hikes in the future and relief policymakers that the current monetary policy direction is the right one. This would also provide some support to the dollar.
The US could be facing symptoms of a broken Philips curve, this being the theory that explains the inverse relationship between the unemployment rate and inflation. Although the unemployment rate dropped to a 16-year low of 4.1% in November, below the Fed’s long-term target of 4.6%, upward pressure on wage growth and consequently inflation remains subdued. Particularly, the annual core PCE index – the Fed’s preferred measure of price growth – has been trending below the Fed’s goal of 2.0% since 2012 and was last seen at 1.4% in October.
Now, analysts expect the gauge to inch up to 1.5% y/y in November. Yet, this might have a modest impact to the dollar as there is currently little room for uncertainty reduction given that the long-awaited tax reforms by the Trump administration intended to deliver massive tax cuts to businesses and individuals have passed Congress, while whether markets price in a third rate hike for 2018 (currently they have priced in slightly less than two), as the Fed projects, is more of an issue that will clear out next year rather than in the remaining few days of 2017. Recall that FOMC members have raised interest rates for the third time this year in December, reiterating that a tighter labor market would drive inflation towards the target in 2019.
But projections for stimulus reduction might alter after Jerome Powell, the next Fed chair replaces Janet Yellen in February and Trump fills four other empty board positions. Despite Powell signaling continuity in policy, the newcomers to join the board could step back and reconsider the current strategy on monetary policy.
Data on personal consumption and personal income are also due on Friday, with analysts projecting personal spending to grow by 0.5% m/m and personal income to stand flat at 0.4% m/m in November.
Looking at the forex markets, dollar/yen could climb to break the previous top at 113.74 if the PCE index surpasses forecasts, opening the scope for a re-test of the eight-month high of 114.72. In the adverse scenario though, worse-than-expected readings could pressure the pair down to meet the 50-day moving average at 112.90. Stepper declines could also find strong support at the 111-112 key area which has been repeatedly tested in the past.
