U.S. CPI inflation rises in JanuaryBut core is unchangedMarkets struggle to digest dataResulting in USD volatility

Above: U.S. CPI inflation breakdown. Image source: @carlquintanilla, Bloomberg.

The Dollar has trended higher in the aftermath of the release of data showing U.S. inflation picked up again in January, defying the Federal Reserve's best efforts to bring an end to historically elevated price rises.

The headline CPI inflation figure rose 6.4% in the year to January, beating expectations for 6.2% but representing a slowdown on the previous month's 6.5%.

The annual rate was underpinned by a rise in prices of 0.5% in the month to January, an acceleration from 0.1% in December.

Core inflation - which is closely watched by the Fed's decision-makers - stayed flat at 0.4% month-on-month in January, which is in line with analyst expectations. "Price pressures were red hot in the US in January," says economist Katherine Judge at CIBC Capital Markets. "Shelter prices were the single largest contributor to the increase."

By the time of writing the Pound to Dollar exchange rate (GBP/USD) is trading back down at 1.2130, having been as high as 1.2269 in the minutes following the release.

The wild ride in FX markets suggests an unease amongst investors as to where inflation is going: if it proves resistant to decline the Federal Reserve will likely proceed with further interest rate hikes, pushing up the cost of finance and forcing the economy into recession.

But should the trend continue lower the Fed will likely end its hiking cycle in the first half of 2023 and potentially be in a position to cut rates towards the third quarter, which is consistent with consensus expectations for U.S. Dollar weakness in 2023.

"No one's mind will be changed by this report," says Ian Shepherdson, Chief Economist at Pantheon Macroeconomics. "Both hawks and doves will find something to highlight. It does not change the very high likelihood of a 25bp hike in March, and it says nothing about May; that’s too far off. "

The return of GBP/USD to 1.2150 takes the typical bank account transfer rate to around 1.1890, competitive holiday money and cash rates to around 1.2000 and competitive transfer provider rates to around 1.2100.

Above: GBP/USD at 5-minute intervals showing market uncertainty in the wake of some stubborn inflation numbers. Consider setting a free FX rate alert here to better time your payment requirements.

What the data is suggesting is that the easy fall back from the peak in inflation at 9.1% in June is now over, and further declines might prove harder to come by.

This poses difficulty for market participants who might grow fearful that inflation might actually begin to increase again.

The data show services inflation continues to grow (see top chart), as are food prices, even as the contribution of commodities and general goods falls.

In fact, were all other components of the inflation basket apart from services to fall to 0%, U.S. inflation would still be above 4.0%, well above the Federal Reserve's target.

But, Claire Fan, Economist at RBC Economics says "one firmer CPI print should not alter the fact that inflation pressures in the U.S. overall have been improving."

She notes the breadth of inflationary pressures continues to narrow and that the Fed's more recently preferred measure for CPI which strips out food, energy and rent inflation (core services CPI ex-rent), has remained roughly unchanged at an annualized 4.1% over the last three months to January.

"That’s still high but has come a long way from over 9% in summer 2022," says Fan.

RBC maintains a view the Federal Reserve to raise the target range by another 25 bp in March, and for that to be their last move this cycle.

Expectations for an end to the Fed's rate hiking cycle have underpinned a recovery in both stock markets and GBP/USD over recent weeks, therefore should the Fed end its hiking cycle in March these trends could extend.