Causes and FX
- 29 April 2024 (10 min read)
Among the rich dataflow of last week in the US, the market focused squarely on the higher-then-expected print for core inflation. As of last Friday, only one-and-a-half rate cuts by the Fed remain priced in for this year. The details of the PCE release brought no more relief than the overall number: services inflation rose again, while manufactured goods inflation moved back in positive territory, on a 3-month annualised basis, for the first time since June of last year. We expect Jay Powell this week to make it plain that the Fed is in no position to cut soon. We still expect the Fed to cut this year though (twice, starting in September), on the assumption that the softer than expected GDP print for Q1– below potential growth for the first time in nearly two years– points to the beginning of a lasting slowdown which would help re-start the disinflation process, especially given the tightening in overall financial conditions, with 10-year yields returning to levels unseen since last autumn.
Still, another dollop of “higher for longer” in the US has serious implications for the rest of the world. While cutting rates in June seems now quite consensual across the Governing Council, hawks may point at the risk of stoking imported inflation in the Euro area via currency depreciation if the ECB diverges too much from the Fed. Banca d’Italia Fabio Panetta made a powerful case for decoupling last week, pointing to the overall tightening in financial conditions which a Fed on hold would trigger for the rest of the world, and we explore in some details a paper Panetta referred in his speech which quantifies the spill-over effects of US monetary policy. We side with him in considering that the optimal reaction of a central bank facing lower inflationary pressure domestically and challenging demand dynamics should be to offset contagion from the US by cutting policy rates. The Bank of Japan is already facing acute pressure on its exchange rate, which has fallen below the levels which had triggered a FX intervention in 2022. The latest inflation data however vindicates Ueda’s cautious approach to policy normalisation.
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