This week there will be headline inflation readings, also known as the consumer price index (CPI), released for three major Western economies:

  • Tuesday, Sept 14: US August CPI expected to grow 5.3% compared to August 2020 (year-on-year, y/y) and 0.4% month-on-month (m/m).
  • Wednesday, Sept 15: UK August CPI forecasted to grow 2.9% y/y and 0.5% m/m.
  • Friday, Sept 17: The final readings of the Eurozone’s CPI is expected to confirm the estimated 3% y/y and 0.4% m/m prints. (The initial figures had been released on 31 August).

Why do central banks focus on inflation?

Part of the mandate for many major central banks is to keep inflation in check to help their respective economies.

Out-of-control inflation could hurt consumers, with lower demand potentially resulting in less hiring as well.

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And thanks to the trillions that central banks have pumped out into their respective financial systems since the pandemic, headline inflation has been surging higher in these major economies!

  • In the US, the headline CPI came in at 5.4% in June and July, which are the highest y/y CPI readings since 2008.
  • In the Eurozone, the estimated 3% y/y CPI reading for August would be its highest in a decade (since 2011). In Germany, the EU’s largest economy, prices last month rose by 3.4% y/y – the most since 2008.
  • For the UK, the forecasted August CPI y/y reading of 2.9% would be its highest since 2017.

Failure to act in a timely manner and curb such inflationary pressures could in turn derail the economic recoveries.

The inflation debate

Yet, central bankers have differing views as to whether these elevated inflation prints are here to stay.

Fed Chair Jerome Powell has long maintained that the inflationary surges of late will be ‘transitory’, or temporary. Likewise, Powell’s counterpart at the European Central Bank, President Christine Lagarde, shares the same view. They think the supply bottlenecks that have contributed to higher inflation would eventually be sorted out, prompting prices to moderate.

However, the likes of Dutch central bank President Klaas Knot and the Austrian central bank Governor Robert Holzmann believe that the higher inflation could stick around for longer. That suggests that the ECB should already start thinking about how to intervene, specifically by way of easing up on its emergency asset purchases (also known as the Pandemic Emergency Purchase Programme or PEPP).

Across the Atlantic, Federal Reserve Bank of Philadelphia President Patrick Harker reportedly just this week voiced his support for a ‘sooner rather than later’ tapering. Similar sentiment has been expressed by Dallas Fed President Robert Kaplan, St. Louis Fed President James Bullard, and Kansas City Fed President Esther George.

And the debate is not confined to just among policymakers, but also playing out across global financial markets as well.

Why markets care what central banks think about inflation?

The inflation outlook is a crucial consideration for the timing of policy moves by central banks.

Overall, should these central banks start unwinding their respective stimulus measures, that should trigger profit-taking in stock markets while spurring their own currency higher.

Note how the benchmark dollar index (DXY), which measures the greenback’s performance against other major G10 currencies, has been lifted onto a higher plane since the Fed started talking about its own tapering plans.

 

Conversely, because the ECB is seen lagging behind the Fed in the path towards normalizing policy closer towards pre-pandemic levels, the euro has been subdued and has been finding it hard to breach the 1.19 mark against the US dollar of late.

 

When comparing how close the ECB’s is to a rate hike versus their counterparts at the Bank of England, with the latter closer to it than the former, that explains in part why EURGBP has been returned back below its 50-day simple moving average (SMA).

 

And although markets are forecasting that the Bank of England’s rate hike would happen sooner than the Fed’s (81% chance of a rate hike by the Bank of England in May 2022, compared to a 77% chance of a Fed rate hike in December 2022), GBPUSD has been confined between a wide range of 1.35-1.40 so far this quarter. This sideways pattern is confirmed by the convergence of its shorter- and longer-term moving averages.

Still, Sterling remains the best-performing G10 currency vs. the US dollar so far this year, with GBPUSD boasting of a 1.24% year-to-date gain. The Pound has also strengthened against all of its G10 peers so far this year.

 

Overall, should the CPI releases for the US, UK, or the Eurozone over the coming days come in higher-than-expected, that could persuade the respective central banks to move closer to adjusting its own policy settings.

The closer each central bank is perceived to be normalizing policy, that could spur that particular currency higher, be it the US dollar, the British Pound, or the euro.

 

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