Inflation vs Unemployment amp FX Implications for UK amp US

Since the start of Fed’s QE3 in September 2012, the decline in US inflation has been three times the rate of decline in US unemployment rate.

It is time markets focused on the proportion of both variables as the Fed’s dual forward guidance is thoroughly put across by the Federal Reserve.

As both inflation and unemployment race to the bottom, understanding the magnitude of both variables and their impact on economic growth becomes vital in assessing clues on Fed policy for 2014, particularly when comparing it to BoE. We repetitively said since September that low inflation figures will be the next trick for the dovish FOMC members to maintain their taperless and low rate credentials over monetary policy.

Inflation Decline since Start of QE3

Since the start of QE3 in September 2012, US inflation (as measured by the Fed’s preferred measure of core PCE price index), has fallen 35% from 1.7% to 1.1% (the lowest since March 2011). Meanwhile, the CPI measure fell by about 40%–from 2.0% y/y in Sep 2012 to 1.2% in November.

With US unemployment rate falling by 11% since September 2012 and inflation falling by three times as much, the Fed’s priority in supressing bond yields will be best grasped via comparing the trends in unemployment relative to inflation to inflation.

Unemployment Divided by Inflation: US vs. UK

Today’s release of 2.1% y/y CPI in the UK is the lowest inflation level in four years. But UK unemployment is also at 4-year lows at 7.6%. For currency traders evaluating the forex impact on GBP and USD from declining inflation and unemployment in the UK and US, one of the suggested methods of comparative analysis for both central banks is via unemployment relative to inflation.

The charts below compare unemployment/ inflation divisors for the US and UK, illustrate that a lower unemployment/inflation divisors (U/I) for the UK at 3.6% (7.6% / 2.1%), versus 6.3% for the US (7.0% / 1.1%).

1. In comparing the absolute value of both nations’ unemployment/inflation divisors (U/I), the consistently lower value for the UK’s U/I reflects the historically higher UK inflation (aka faster declining US inflation), particularly since September 2012, thereby suggesting more “hawkish premium” for GBP over USD.
2. In comparing the trend/divergence of both nations’ unemployment/inflation divisors, the rising trend of US unemployment/inflation away from that of the UK also reflects the continuous dovishness of the Fed relative to the BoE.

Despite the fact that US unemployment of 7.0% is lower than the UK’s 7.6%, the U/I is higher for the US, highlighting the accelerating decline in US inflation. If the divergence continues, then favouring GBP over USD in 2014 on the basis of Fed/BoE opens the door for $1.6700 in GBPUSD in late Q1 2014, when an eventual tapering of the Fed would be likely offset by slashing interest on reserves.