Markets are slowly pricing in additional quantitative easing from the Fed but rising inflationary pressures suggest the central bank may be constrained to implement further measures. Today’s CPI data is all the more important for equity markets expecting a ‘Bernanke Put’.
In line with the current ultra-loose monetary policy US inflation has seen an uptick in recent months. While never officially called ‘Quantitative Easing’ the Fed’s policy of asset purchases to lower interest rates was designed to provide a burst of inflation to stave off potentially damaging deflationary forces. In light of QE1 and QE2 the Fed looks to have succeeded in its mission. In May consumer prices rose 3.6% y/y, up sharply from the previous three months. The headline June CPI number actually declined by 0.2% but the drop is largely due to a decline in gasoline prices. In contrast core CPI increased 0.3%, driven by rising food costs. Yesterday’s rise in June PPI report suggests that producers are succeeding in passing on their increased costs to the US consumer who in turn is willing to pay higher prices.
While Fed Chairman Bernanke maintains the position that US inflation is transitory, the data suggests the risk of deflation is slowly disappearing. As shown by last week’s FOMC vote which had three dissenters against the pre-committed interest rate targeting Bernanke will face a difficult task convincing the FOMC another round of asset purchases is necessary given the rising prices in the US economy and the risk of inflation spiraling out of control. Yesterday Philadelphia Fed President Charles Plosser said the Fed may need to raise rates before mid-2013, in stark opposition to last week’s FOMC statement.
Those equity traders who are looking for the ‘Bernanke Put’ may also be disappointed. Comments yesterday by Dallas Fed President Richard Fisher describe the Fed is not the protectors of stock market traders and investors. This suggests the real economy will need to show slowing growth rates and equity markets will have further room for declines before the Fed would step in to support the markets. However, a repeat of Monday’s 6.6% decline in the S&P 500 could initiate QE3 regardless of the inflationary risks the Fed faces as Bernanke has said higher equity prices are one way the Fed measures the success of its QE efforts. Today’s July CPI data carries all the more importance.
Looking out towards the medium term, reduced expectations of additional US monetary policy may be a catalyst for the USD. While increasing interest rate expectations might be asking for too much given the Fed’s recent commitment to low rates until mid-2013, only the expectation of future monetary policy tightening would be needed to prove USD supportive. A similar view has been taken in the market regarding US fiscal credibility following the compromise between the President and Republicans to raise the debt ceiling, putting the US on a path to fiscal austerity. The prospects of a credible fiscal policy combined with an end to quantitative easing measures could be viewed as a turning point in the 13-month bearish USD trend versus the EUR.
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