Deutsche Bank: The Fed Can Declare Mission Accomplished on Inflation

Past dollar strength explains the current shortfall.

Morgan Stanley's Zentner: Fed Is Itching to Move Rates

The Federal Reserve doesn't have to worry about too-low inflation, according to Deutsche Bank AG.

The central bank's preferred gauge of price pressures — the annual growth of the core Personal Consumption Expenditures (PCE) index — may seem below target at 1.6 percent, but would already be right around 2 percent if not for the prior strength of the U.S. dollar.

The rally in the greenback from mid-2014 until early 2016 is exerting the largest drag on core inflation since the late 1990s, says Chief Global Strategist Bankim "Binky" Chadha, and making it seem as though the Fed hasn't met both parts of its dual mandate of full employment and price stability.

"A principal reason the Fed has continued to maintain extraordinarily low policy rates has been its reading that inflation is too low and concerns about it returning to the 2 percent target," he writes. "Adjusted for the dollar’s moves, underlying or constant-currency core PCE inflation rose from a low of 1.0 percent in the aftermath of the financial cCrisis to 2 percent in February 2016."

Source: Deutsche Bank

The Fed has often referenced past exchange rate movements when explaining why inflation continues to run below its target, and this "temporary" drag can prove to endure for an extended period of time.

The impact of the dollar on headline inflation happens fairly quickly in light of the direct impact it has on commodity prices. Exchange rate movements take considerably more time (up to two years, Deutsche Bank reckons) to fully pass through to core.

"The dollar impacts core inflation through (i) import prices; (ii) import-competing effects; and (iii) changes in oil and commodity prices that affect the cost of producing other goods," writes Chadha.

In fact, it's almost as if the Fed needs a weak dollar in order to hit above its core PCE target. Over the past 20 years, the majority of instances in which this index was at over above 2 percent occurred amid a bear market for the greenback in the aughts.

This begs the question of whether the Fed is using the most appropriate barometer of price pressures when calibrating monetary policy, an issue Chadha's colleague Chief U.S. Economist Joe LaVorgna raised in September last year.

Roughly half of the difference between core CPI, which has run above 2 percent since December, and core PCE is a reflection of the U.S. dollar's past strength, said Chadha.

The effect of the greenback on core PCE also helps explain why the Phillips Curve, which depicts the presumptive inverse relationship between the unemployment rate and inflation, appears to be broken in the U.S.

DB Phillips
Source: Deutsche Bank

This implies that the Fed can continue to be confident that a reduction in labor slack will materialize as higher inflation, rather than wait for realized progress on core PCE before continuing the tightening cycle, as officials including Chicago Fed President Charles Evans have argued. In addition, Chadha's analysis undercuts the case that fiscal stimulus is needed to boost aggregate demand in order to bring inflation to target.

"The combination of a receding dollar drag and continued labor market tightening should see core PCE inflation move up and through 2 percent over the next two years," he concludes.