NEWS / Foreign Debt

Forex: FXA Alert. PCE Price Story - Compelling Evidence For August 08 Rate Hike

Dallas Fed puts out a handy table on PCE prices...it looks at headline PCE prices annualized for one-month change, six-month change and twelve-month change (open attached document for tables). It also has its own "mean trimmed" measure. No matter how you slice it, the PCE price index is compelling evidence that core inflation is accelerating and demands a rate hike...risk management insurance...come August 08. However, the Fed is also clearly eager to pause and spend at least the intra-meeting period assessing incoming data before potentially raising rates again especially in light of the slowing in the US economy in 2Q to 2.5% pace from 5.6% in 1Q. The Fed knows that inflation peaks well after a turn in the business cycle and so that is the bet...pause, betting the economic slowdown will check inflation or take out a little more insurance that the economy can withstand an eighteenth straight hike without much of a risk of a hard landing (overshooting), particularly in light of firm foreign demand and the less certain assumption about strong business investment (latest data suggest not living up to billing).

My coin toss for August 08 comes up pause. But this will require a very deliberate attempt, in the FOMC statement, to let markets know that a rate hike can be expected September 20 if price pressures persist and growth in 3Q looks like it will pick up from 2Q pace.

Okay, that is the very near-term for the Fed. For those looking out a few more FOMC meetings, the likelihood of the economy slowing is likely to grow into year-end and bring highly certain end to Fed tightening and begin to get markets thinking about Fed easing in 2007.

I think there are near-term downside risks to Tsys given inflation story (again captured in core PCE) but expect Tsy prices to rally in the 4Q. The dollar is likely to grind lower and gradually due to the nagging inflation problem and pressure on the Fed to keep addressing price stability. But I also think that late stage rate hikes work against the dollar in time as markets move to discounting the overshooting risk which would be worse for the dollar than a well justified and market-supported early pause in rates.

David Gilmore
FXA
www.fxa.com