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The Dollar is a loser in the evolving ’stagflation trade’. The Federal Reserve won’t ride to the rescue of under-pressure investors next week when it meets to decide on interest rates.
This is because emerging signs of stagflationary conditions will limit the Fed’s freedom to cut interest rates and support the economy.
U.S. stock markets and the dollar are falling in tandem due to fears that the U.S. economy is entering a period of falling growth and rising inflation, or stagflation.
Although headline inflation released on Wednesday came in below expectations, economists agree that all signs point to a rise in inflation in the coming months, largely due to President Donald Trump’s policy agenda.
"The large uncertainty shock caused by the erratic economic policy announcements of the Trump administration greatly complicates the Fed’s task. Surveys show that businesses and consumers expect inflation to rise as a result of the tariffs," says Paolo Zanghieri, Senior Economist at Generali (BIT:GASI) Investments.
The Federal Reserve would usually respond to falling growth by cutting interest rates, but the inflationary aspect of the dynamic will severely constrain it.
This leaves investors high and dry, as in the past, the ’Fed put’ - a rate cut - would come to their rescue.
"Trade tensions hurt growth, but tariffs’ inflationary effects will prevent the Fed from easing. Risk assets are thus likely to remain under pressure," says BCA Research in a new note.
The Dollar usually rises in tandem with rising inflation expectations; however, in the ’stagflation trade’, the Dollar is reined in by equity market and economic growth underperformance.
BCA says leading indicators of the U.S. economy and inflation expectations paint a worrying picture. Both have rebounded, and most of the February data sent a stagflationary message."
Headline U.S. inflation is vulnerable to a rebound if falling goods prices start rising again. "Tariffs will start impacting goods prices in the coming months," explains BCA.
U.S. consumer prices rose by 0.2% in February, the smallest increase since October, following a 0.5% rise in January, according to data released by the Labor Department on Wednesday.
"We’d be inclined to downplay this improvement though, not because of the influence of the more volatile components but because of how future risks are likely to feed in," says Sam Hill, Head of Market Insights at Lloyds (LON:LLOY) Bank.
Lloyds Bank, like BCA, warns that the deflation in goods prices, which has kept headline inflation in check, will soon end.
"That does not look demand driven, but in response to rising import costs (aka tariffs)," says Hill.
An original version of this article can be viewed at Pound Sterling Live