US Inflation Preview: High bar for underlying prices set to undercut US Dollar

• Economists expect the US to report another increase of 0.3% in underlying inflation.
• Upbeat producer prices imply even higher expectations from market participants.
• A minor miss would trigger significant US Dollar losses.
• The Greenback has been under pressure from dovish Federal Reserve remarks.

The pendulum has been swinging against the US Dollar – and it is not over yet. A mix of high expectations and headwinds imply another leg down for the embattled Greenback in response to the all-important inflation data.

Here is a preview of the Consumer Price Index (CPI) release for September, due on Thursday at 12:30 GMT.

CPI background and why critical data may miss estimates

The Federal Reserve (Fed) has been laser-focused on fighting inflation and has been sticking to the mantra of following the data. Investors have been following the bank's words – at least when it comes to wild responses to economic releases. 

CPI inflation is the earliest hard data of price rises, making them a massive market-mover. Moreover, with doubts about the next rate decision, which would be the last, investors are set to react with vigor. 

Headline inflation has been falling below 4% YoY, but Core CPI – which excludes energy and food – is stickier. Underlying prices depend on services, and especially wages, which refuse to drop. Core CPI YoY stood at 4.3% in August, and economists expect it to stay above 4%, hitting 4.1% in September. 

More importantly, the economic calendar points to a MoM increase of 0.3%, which would represent an annualized increase of roughly 4% – too hot. It would also be a repeat of last month's outcome.

US Core CPI MoM. Source: FXStreet.

These expectations are too high. Why? Recent ISM surveys have been pointing lower, and moderation was also seen in recent wage data. Average Hourly Earnings advanced by only 0.2%, below the 0.3% expected for August. As mentioned above, salaries tend to fall slowly, and they play a critical role in inflation. 

Real estimates may be even higher. The Producer Price Index (PPI) and all its components exceeded forecasts in the report for September. When PPI is released before CPI, the former shapes expectations for the latter. However, producer prices propagate into the economy with a lag – and the two are not always well-correlated.

All in all, there is room for a downside surprise.

Inflation and the US Dollar backdrop

The Greenback has been on the back foot as yields come down. Geopolitical worries due to the brutal attack by Hamas on Israel, concerns about China's lackluster expansion and also lower wages contributed to the retreat from the peak.

Moreover, Fed officials have repeatedly said that elevated returns on long-term bonds curb inflation. That makes additional rate hikes unnecessary. Yields on 10-year bonds have dropped from a peak near 4.90% to 4.55% at the time of writing. 

If yields continue their rapid descent, the Fed would need to talk tough once again. However, without an upside surprise, the US Dollar is set to extend its downside move. 

Final thoughts

The CPI is a major market mover, and it sets expectations for the next Fed decision and beyond. The ingredients for another Dollar drop are in the pot.