Inflation and the USD Q&A

Posted by Neil Hume on Oct 28 16:48.
 
Q: How much does the USD need to fall to meaningfully boost US inflation?
A: A lot.
That’s the conclusion of a benchmarking exercise Goldman Sachs has run on dollar weakness and inflation and explains why Jan Hatzuis and his team believe the Fed needs to buy $2,000bn of assets under QE2 if it serious about hitting its inflation and unemployment targets. A couple of hundred billion here or there is just not going to cut it.
The report finds that:

• statistically, the pass-through from USD declines into US inflation has always been low, and appears to have fallen to near negligible levels in recent years.

• USD needs to fall a lot further – even after recent  declines – to contribute to raising inflation towards the Fed’s desired level.

• Ultimately, core inflation remains hostage to movements in components which are driven by domestic developments rather than external.

Historically, only a relatively small fraction of a Dollar fall is ‘passed through’ into consumer prices. For example, a paper by researchers at the Fed concludes based on data from 1981 to 2000 that a 10 percent decline in the trade-weighted Dollar boosts inflation by only around 30 bps, a very small effect. The small magnitude of this effect reflects a variety of factors, among which perhaps the most important is the desire of foreign exporters to preserve market share in the US, which means that they tend to react to Dollar falls by accepting smaller profit margins rather than hiking prices.

What all this points to is that – in line with the academic literature – the ‘pass-through’ from Dollar declines to US consumer price inflation is small. This in turn means that – if indeed the Fed sees the Dollar as one of its key policy levers for preventing inflation from staying below its mandate for a prolonged period – the Dollar needs to fall a lot further from here.

Ultimately, core CPI inflation remains hostage to the slowdown in rental (shelter) price and services (less shelter) price inflation – a point we have made repeatedly in our research and one of the main reasons why our bond forecasts have been below the forwards over the past 18-months. These components represent a significant component of the core inflation rate at approximately 31.9% and 28.3% respectively and are typically determined largely by domestic as opposed to external factors. And so as domestic conditions remain depressed, core inflation is likely to remain below levels the Fed would consider consistent with its mandate for some time.

Sadly Goldman doesn’t spell out what “a lot further from here” means. All we do know is that it’s Markets team are forecasting a further 5 per cent decline in the Dollar on a  broad, trade-weighted basis over the next 12 months.

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