US CPI Preview: Soft core set to drive dollar down, and two other scenarios

• US core inflation is critical to the next dollar move. 
• Expectations for 0.5% MoM in May seem overblown after weak wage growth.
• A narrative of peak inflation may take hold and weigh on the greenback.
• Alternative scenarios would keep the dollar afloat for longer. 

"Unacceptable levels of inflation" – these are the latest words from Treasury Secretary Janet Yellen, which reflect how rising prices are critical to politics, the economy and monetary policy affecting currency. That is what makes the Consumer Price Index – the earliest direct gauge of inflation – a critical dollar mover.

Jerome Powell, Yellen's successor at the helm of the Federal Reserve, has also offered strong words against what he previously labeled as only transitory. While the price at the pump is what most irritates voters and politicians, there is little the Fed can do about global oil and food prices, it can influence core inflation – prices of everything else. 

Smoke signs of peak inflation

Moreover, Powell committed to battling rising prices, even at the expense of accepting higher unemployment and a "softish" landing – aka a mild recession. There are several early, tentative indications that inflation is off its highs. 

First, the University of Michigan's Consumer Sentiment Index's inflation expectations gauge – yes, I know it is a mouthful – was downgraded from 5.4% to 5.3%. While the drop is minor, it shows that shoppers are anticipating somewhat lower price rises in the future.

Second, Average Hourly Earnings – aka salaries – missed estimates in the past two months, rising by only 0.3% MoM. If people have less money in their pockets, they buy fewer goods. 

Third, Target, a major retailer, issued a profit warning due to lower sales than expected. The company hoarded goods in anticipation of high demand and is now stuck with packed storage. When supply is high and demand is low, the best way to make money is to lower prices – adding disinflationary pressures.

A consumer survey is not hard data, two months of lower salary growth does mean pay cannot rise, and Target is not the only company in America. The real test comes now, with the all-important Core CPI figure.

Great expectations

I prefer focusing on the monthly figures, as base effects skew the yearly data – prices leaped in May 2021, the month that now falls out of the calculation. Therefore, Core CPI YoY will likely be down, and that would be no surprise. What matters is the monthly change.

The FXStreet Economic Calendar shows that economists expect another robust increase of 0.5% in Core CPI MoM, coming on top of last month's 0.6% increase. However, I think these estimates are over the top.

Source: FXStreet

Why are these projections exaggerated? As mentioned earlier, there are signs of easing price pressures. Most importantly, wages advanced by only 0.3% in both April and May, a total of 0.6%, while expectations imply an accumulated gain of 1.1% in Core CPI. Such a mismatch cannot be ruled out, but seems unlikely.

Three scenarios

1) As expected: A monthly increase of 0.5% in underlying prices means inflationary pressures are far from easing, and that a 50 bps rate hike in September is on the cards. The Fed has already pledged to increase borrowing costs by 50 bps – a double dose in comparison to the recent past – in both June and July. 

For the dollar, both 0.5% and 0.4% would represent persistently high inflation that the Fed would feel obliged to fight with full force. A 0.4% monthly increase would represent roughly 5% annualized advances, which is far above its 2% target. 

On the other hand, both 0.4% and 0.5% would be lower than April's figure and would also leave the option of 25 bps on the table. In this scenario, I expect the dollar to edge higher, but that any such move would be limited in size. 

I think this scenario has a medium probability. 

2) Below expectations: An increase of 0.3% or 0.2% would imply a substantial relief in price pressures and growing talk that inflation has already peaked. It would ease pressure on the Fed to act beyond what it pledged – opening the door for a September pause. 

The dollar would fall significantly in such a scenario – which I see as highly probable given what I have discussed above. A rush to close positions ahead of the weekend would exacerbate such falls.

3) Above expectations: Core CPI surprised in April, and another upside surprise cannot be ruled out for May. The US consumer is relentless, and should never be underestimated. 

While the probability is low in my opinion, such a surge would raise expectations for more drastic moves by the Fed – 50 bps hikes in September and November, and perhaps a shocking 75 bps hike as early as next week. 

In this scenario, the dollar would surge and stocks would fall. Once again, a scramble to act before trading closes for the weekend could trigger a massive sell-off in stocks, adding safe-haven flows to the dollar rally. 

Final thoughts

US inflation is of the highest importance – and dare I say, even exceeding Nonfarm Payrolls. Any deviation worth 0.1% is critical to the greenback's moves. As usual, USD/JPY tends to react best to US economic releases, as it is well-correlated with US yields. EUR/USD would be influenced by the ECB and GBP/USD is whipsawed by politics. Of the top assets, perhaps only gold is also worth trading around the event, as it is sensitive to yields, like USD/JPY.