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Annual Inflation Peaks in November

This morning, the Bureau of Labor Statistics released consumer inflation numbers for November. The Consumer Price Index for all Urban Consumers (CPI-U) was unchanged for the month following seasonal adjustments. This is what most analysts had expected. As the chart below illustrates, net inflation since July remains flat. November saw declines in energy and food costs offset by higher prices for shelter and medical care services. For the 12-months ending in November, the headline index rose an unadjusted 0.5%, the highest annual inflation number since 2014.

monthly CPI Nov

Excluding food and energy, seasonally adjusted core prices rose 0.2% in November, which was also what most analysts had forecast. Adjusted core prices have increased by 0.2% for three months in a row and have stayed between 0.1% and 0.3% throughout 2015. For the year ending in November, core inflation was 2%.

Core vs ALL

These numbers point to underlying inflationary pressure and support the Federal Reserve’s highly anticipated rate hike, which will likely be announced tomorrow following their meeting. The Fed has kept interest rates at 0.25% since 2009.

November’s Inflation

Overall, seasonally adjusted prices were flat in November as declines in the indexes for food and energy were offset by higher prices for shelter, transportation services and medical services. The index for all items less food and energy climbed a seasonally adjusted 0.2% in November, in line with expectations. The more volatile food and energy indexes were down 0.1% and 1.3% respectively, after seasonal adjustments.

Seasonally Adjusted Monthly % Change in CPI-U by Category (2016)

JanuaryFebruaryMarchAprilMayJuneJuly
All Items0-0.20.10.40.20.20.0
Food00.2-0.20.2-0.2-0.10.0
Energy-2.8-6.00.93.41.21.3-1.6
Gasoline-4.8-12.52.28.12.33.3-4.7
Fuel Oil (non seasonally adjusted)-6.5-2.91.71.96.23.7-1.5
Electricity-0.7-0.20.4-0.3-0.2-0.50.5
Utilities (piped gas service)-0.61.0-0.70.61.7-0.43.1
Energy Services-0.70.10.2-0.10.2-0.51.0
All Items Less Food and Energy0.30.30.10.20.20.20.1
Services Less Energy Services0.30.30.20.30.40.30.2
Shelter0.30.30.20.30.40.30.2
Transportation Services0.40.20.20.70.30.3-0.2
Medical Care Services0.50.50.10.30.50.20.5

The monthly decline in the food index is its first drop in 8 months. The index for food at home fell 0.3% in November. Aside from fruits and vegetables, which were 0.6% higher for the month, every other component of the index for food at home fell. Prices for meat, fish, poultry and dairy products continue to decline.  However, the adjusted index for food away from home climbed 0.2% in November.

The decline in the energy index resulted from lower gas prices, down a seasonally adjusted 2.4% in November. Gas prices have been very volatile in 2015, falling over 18% in January and climbing over 10% in May. Shelter costs continue to rise steadily, up 0.2% in November following increases of 0.3% in September and October. Prices are also rising steadily in the service sectors, up 0.3% for the third month in a row. Transportation and medical care services were up 0.6% and 0.4% respectively.

Annual Inflation

For the 12-months ending in November, unadjusted prices were up 0.5% overall. The increase in overall price levels was largely driven by higher shelter costs, which account for 33.2% of the overall index. Unadjusted shelter costs were 3.2% higher over the 12-month period. The index for rental costs (primary residence) climbed 3.6% during the year, while moving expenses were 7.1% higher.

Food prices, which account for about 14% of the overall index, were up 1.3% for the year ending in November. The index for food at home, which is about 60% of the overall food index was only up 0.3% year over year. This marks its smallest annual increase in over 5 years. The prices for meat, fish, poultry and eggs are all down year over year while the prices for bread, fruits and vegetables are higher.  The index for food away from home climbed 2.7%. A significant hike (4.9%) in the index for food at employee sites and schools was the primary reason for higher costs for food away from home.

The energy index makes up approximately 7.4% of the CPI-U and about half of the energy index is energy commodities and the other half energy services. For the year ending in November, the overall energy index fell 14.7% including a 24.2% decline in energy commodities and a 2.8% decline in energy services. Among the energy commodities, the index for fuel oil had the largest decline, down 31.4% for the year. Over the same 12-months, the index for gasoline (all types) fell 24.1%.

Outlook

It is highly expected that the Federal Reserve will raise interest rates by a quarter of a percentage point on Wednesday. According to the Wall Street Journal, 97% of economists surveyed expect the fed to raise rates this week. This would be the first rate hike in nearly a decade as the economy and employment appear to finally be returning to solid ground.

What remains largely an unknown at this point is the pace of future rate hikes. This will largely be a function of inflation expectations.  With overall inflation continuing to lag well below the Fed’s target, the pace of future rate hikes may likely be slow. According to David Jones, chief economist at DMJ Advisors:

The stronger dollar and falling oil prices [may] have masked some underlying inflation[ary] pressures which could surface quickly as we move closer to full employment.”

Fed Funds Rate

October Inflation in Line With Expectations

The BLS released October’s inflation data this morning and there were no major surprises. The Consumer Price Index for All Urban Consumers (CPI-U) climbed  a seasonally adjusted 0.2% in October following a decline of 0.2% in September. This is in line with consensus expectations. Year over year, the CPI-U was up 0.2% at the end of October, which is well below the Fed’s annual inflation target rate of 2%. According to a recent Federal Reserve press release:

“Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.”

Core inflation, which excludes food and energy, increased 0.2% in October, following a 0.2% increase in September. For the year ending in October, core inflation was 1.9%. Outside of the volatile energy index, which was down over 17% for the 12-months ending in October, consumer prices appear to be climbing at a steady pace only marginally below the Fed’s target.

October’s Seasonally Adjusted Inflation

October’s 0.2% climb in consumer prices was largely driven by modest increases in the energy index, which rose 0.3% following a decline of 4.7% in September. Gas prices were up 0.4% in October compared to a 9% decline in September (this still leaves gas prices down 27.8% year over year).

A 0.8% spike in the index for medical care services also helped drive October’s inflation. This includes a significant jump in the hospital services index, up 2% in October. Overall, medical care costs posted a 0.7% gain in October including a 2.3% jump in the costs of inpatient services and a 1.7% rise in the costs of outpatient services.

Four of the six major grocery store food groups saw prices rise in October. The overall food index rose a modest 0.1%, following a 0.4% rise in September. The price of fruits and vegetables climbed 0.5% in October, while the index for meat, poultry, fish and eggs fell by the same amount, despite a 3.4% increase in the cost of bacon and bacon related products. A fall of 4.8% in the price of eggs was particularly notable for the month. Breakfast cereal and butter posted strong price gains, rising 2.4% and 5.3% in October.

Shelter costs continued to climb steadily, up 0.3% in October, matching Septembers change.  Shelter costs have risen between 0.2% and 0.4% every month this year. The index for lodging away from home, up 0.8% in October, contributed significantly to higher shelter costs, .

The apparel index was down 0.8% in October. There was a large amount of variation within the index. The index for boys apparel climbed 2.9% while the index for girls apparel fell by 2.9%. Delivery services also fell in October, down 2%.

Seasonally Adjusted Monthly % Change in CPI-U by Category (2016)

JanuaryFebruaryMarchAprilMayJuneJuly
All Items0-0.20.10.40.20.20.0
Food00.2-0.20.2-0.2-0.10.0
Energy-2.8-6.00.93.41.21.3-1.6
Gasoline-4.8-12.52.28.12.33.3-4.7
Fuel Oil (non seasonally adjusted)-6.5-2.91.71.96.23.7-1.5
Electricity-0.7-0.20.4-0.3-0.2-0.50.5
Utilities (piped gas service)-0.61.0-0.70.61.7-0.43.1
Energy Services-0.70.10.2-0.10.2-0.51.0
All Items Less Food and Energy0.30.30.10.20.20.20.1
Services Less Energy Services0.30.30.20.30.40.30.2
Shelter0.30.30.20.30.40.30.2
Transportation Services0.40.20.20.70.30.3-0.2
Medical Care Services0.50.50.10.30.50.20.5

12-Month Inflation

For the 12-months ending in October, unadjusted inflation was 0.2%. This includes a 27.8% decline in the index for energy commodities, which accounts for roughly 3.8% of the total CPI-U. The overall energy index fell 17.1% for the year. Despite the strong negative impact of energy prices, the CPI-U is marginally higher for the year.

Food prices, which account for over 14% of the overall price index, were up 1.6% year over year. Annual changes in food prices were mixed. Eggs were 30% more expensive than they were one year earlier. Over the same period, milk became 7.5% cheaper and the index for salt and seasoning rose 7.0%. Food at employee sites and schools was 5% higher for the year.

The prices of many consumer goods became cheaper over the year. The indexes for apparel and for appliances posted 1.9% and 4% declines respectively. The price of a television set has fallen 13.3% year over year, while the index for toys was down 6%. On the other hand, the cost of shelter rose 3.2% for the year with moving costs up 6.4%.

Outlook for the Fed

Most economists expect the Fed to raise interest rates in December, which would be the first rate hike in over 9 years. Today’s inflation release should not have a significant impact on these expectations. Fed fund futures are pricing in a 73.6% likelihood of a 0.25% rate hike on December 16th, which would bring the Fed Funds rate to 0.5%. The level of uncertainty around this highly anticipated hike and the pace of tightening over the coming years is unprecedented.

The modest but steady growth in the U.S. economy is in stark contrast to slowdowns in much of the world. With the EU considering quantitative easing and Japan dipping into recession, international money is flowing into the U.S. economy, driving the dollar higher. A rate hike would put further upward pressure on the U.S. dollar, which would create a slowdown in domestic manufacturing. It would also make imports cheaper, potentially keeping inflation from moving towards the target rate. The graph below shows the U.S. dollar reaching its highest level in 10 years versus a basket of international currencies. This should be a major concern at the next FOMC meeting on December 15th and 16th.

Screen Shot 2015-11-17 at 8.49.13 AM

Annual Inflation Flat as Consumer Prices Decline in September

Falling gas prices kept inflation below zero for the  month of August. The BLS announced this morning that the Consumer Price Index for All Urban Consumers (CPI-U) fell 0.2% in September on a seasonally adjusted basis; this is in line with expectations. In August, the CPI-U fell 0.1% following 6 straight months of growth. Gas prices also drove the decline in August’s CPI-U number. September’s decline wiped out the annual gains of 0.2% that were posted at the end of August, leaving the CPI-U flat for the year ending in September.

Screen Shot 2015-10-15 at 8.36.20 AM

The index for all items less food and energy was up 0.2% in September, following increases of 0.1% in both July and August. For the 12-months ending in September, this core index increased 1.9%, pointing to more robust underlying growth for the U.S. economy. This is the highest annual core inflation number since July 2014. As the graph above shows, the disparity between overall consumer prices and consumer prices less food and energy continues to grow.

Energy Prices

The decline in overall consumer prices in September was largely driven by falling gasoline prices, which were down a seasonally adjusted 9% in the month alone.  Over the same period, the energy index fell 4.7%, adding to August’s 2% decline. The energy index accounts for about 8% of the CPI-U and gasoline about 4%.

Volatile gasoline and energy prices have driven overall price levels and kept inflation very low over the past year. The energy index is down 9.7% for the year ending in September. Over this period, the biggest price declines were seen in the price of gasoline and fuel oil, down 18% and 18.6% respectively.

Seasonally Adjusted Monthly Numbers

On a seasonally adjusted basis, the CPI fell 0.2% in September following a decline of 0.1% in August.

Seasonally Adjusted Monthly % Change in CPI-U by Category (2016)

JanuaryFebruaryMarchAprilMayJuneJuly
All Items0-0.20.10.40.20.20.0
Food00.2-0.20.2-0.2-0.10.0
Energy-2.8-6.00.93.41.21.3-1.6
Gasoline-4.8-12.52.28.12.33.3-4.7
Fuel Oil (non seasonally adjusted)-6.5-2.91.71.96.23.7-1.5
Electricity-0.7-0.20.4-0.3-0.2-0.50.5
Utilities (piped gas service)-0.61.0-0.70.61.7-0.43.1
Energy Services-0.70.10.2-0.10.2-0.51.0
All Items Less Food and Energy0.30.30.10.20.20.20.1
Services Less Energy Services0.30.30.20.30.40.30.2
Shelter0.30.30.20.30.40.30.2
Transportation Services0.40.20.20.70.30.3-0.2
Medical Care Services0.50.50.10.30.50.20.5

The price of food climbed 0.4% in September, adding to August’s 0.2% increase in the food index. Higher prices for dairy and fruits and vegetables, including a 4.7% spike in the price of lettuce, were somewhat offset by declines in the prices for fish and poultry. The index that measures the price of food in primary and secondary schools was 7.2% higher in September alone.

The shelter index continues to climb, up 0.3% in September, following increases of between 0.2% and 0.4% per month since the beginning of the year. In September, higher shelter costs were the result of higher prices for hotels and lodging away from home. The rent index, which is part of the shelter index, climbed 0.4% in September. Shelter costs account for about one third of the CPI-U.

The medical care index was up 0.2% in September, including increases of 0.3% for medical care services and 0.6% for health insurance. At the same time, the costs for both prescription drugs and medical equipment and supplies were down 0.2%.

Following four months of declines, the index for household furnishings and operations increased 0.4% in September despite a fall of 0.7% in the price of floor coverings. Indoor plants and flowers were significantly more expensive, gaining 2.4% in September.

The index for apparel fell 0.3% in September, following two months of gains. September’s apparel number masks volatility within the index. On a seasonally adjusted basis, the prices for men’s outerwear fell 3.9% and girl’s apparel was down 3.7%. At the same time, the price of men’s sweaters climbed 8.7%.

Annual Inflation

September’s declining CPI-U wiped out any 12-month gains, leaving overall price levels flat for the year. Higher prices for most components of the index were just able to balance the 12-month 18.4% decline in energy prices. The food index was 1.6% higher for the 12-month period and Shelter costs climbed 3.7%. Transportation services were 2.2% higher, including increases of over 5% for both car and truck rentals and vehicle insurance. Significant 12-month price hikes were also posted for animal services including veterinary services (up 4.3%), admission to sporting events (up 7.8%) and childcare and nursery school fees (up 4.2%). In general, higher prices were recorded for most services. Financial service costs were nearly 4% higher for the year, including an increase of 5.1% for tax and accounting services.

Price declines over the past year include the cost of cell phone services (down 3.8%) and the index for cell phone hardware, calculators and consumer information items, which tumbled 15.8%. Airline fares were down 6% for the year as was the price of toys. Television sets became over 13% less expensive compared to a year earlier and the price of appliances in general fell 3.5%.

Economic Outlook

Today’s inflation numbers will be watched closely as the Federal Reserve appears divided over the possibility of an interest rate hike later in the year. Stronger inflation numbers would have suggested that the economy was more robust and ready for higher interest rates. However, today’s weak inflation data, although expected, add to a series of disappointing indicators.

The Producer Price Index, a principal gauge of inflation in the manufacturing sector, declined by 0.5% in September, its weakest number in 7 months. September retails sales were also a disappointment, missing expectations at 0.1% versus the expected 0.2%. Core retail sales slipped 0.3% below the expected decline of 0.1%. The U.S. dollar has also been falling due to a disappointing jobs report in September.

The next Federal Open Market Committee meeting is October 27-28. The markets have been pricing in approximately a 39% chance of a rate hike in December. However, this number has been declining following downturns in global and emerging markets. Today’s CPI-U numbers will not reverse the trend. Rates are likely to remain unchanged until at least March of next year.

August Inflation Stifled by Falling Gas Prices

cpi gasJust ahead of the the FOMC’s two day deliberation over a potential interest rate hike, the BLS released August’s inflation data this morning. Headline inflation or the Consumer Price Index for Urban Consumers (CPI-U) fell a seasonally adjusted 0.1% for the month of August, in line with economists’ expectations. This follows July’s lacklustre 0.1% CPI-U growth which was below expectations. For the year ending in August, non-seasonally adjusted overall inflation was 0.2% for the second month in  row.

Core Inflation, which excludes food and energy was up a seasonally adjusted 0.1% in the month of August.  This follows  an increase of 0.1% in July, which was driven by a spike in the cost of shelter. We continue to see a large disparity between core and overall CPI as food and energy prices remain very volitile. CPI chart

Seasonally Adjusted Monthly Numbers

In August, lower energy prices were not quite offset by higher prices for food, apparel and energy services, sending seasonally adjusted inflation below zero for the month.

Seasonally Adjusted Monthly % Change in CPI-U by Category (2016)

JanuaryFebruaryMarchAprilMayJuneJuly
All Items0-0.20.10.40.20.20.0
Food00.2-0.20.2-0.2-0.10.0
Energy-2.8-6.00.93.41.21.3-1.6
Gasoline-4.8-12.52.28.12.33.3-4.7
Fuel Oil (non seasonally adjusted)-6.5-2.91.71.96.23.7-1.5
Electricity-0.7-0.20.4-0.3-0.2-0.50.5
Utilities (piped gas service)-0.61.0-0.70.61.7-0.43.1
Energy Services-0.70.10.2-0.10.2-0.51.0
All Items Less Food and Energy0.30.30.10.20.20.20.1
Services Less Energy Services0.30.30.20.30.40.30.2
Shelter0.30.30.20.30.40.30.2
Transportation Services0.40.20.20.70.30.3-0.2
Medical Care Services0.50.50.10.30.50.20.5

The energy index was down 2.0% for the month for August due to a drop in gas prices. On a seasonally adjusted basis, the gasoline index fell 4.1% in August following 3 consecutive months of growth including a 10.4% spike in May. Before seasonal adjustments, gas prices were 5.4% lower in August (see graph below). The price of fuel oil also fell a drastic 8.1% in August adding to declines in June and July. At the same time, energy services including electricity and piped gas were more expensive in August, climbing a seasonally adjusted 0.3% and 1.2% respectively.

The index for food climbed 0.2% in August, driven by significant growth in the price of fruits, vegetables and eggs. The fruits and vegetable index was 1.5% higher for the month. The price of eggs also spiked 7.7% while the indexes for meat, fish and poultry were generally lower.

Without food and energy, which are very volatile, the index for all items or core index increased 0.1% for the second consecutive month. This includes the shelter index which continues to climb, increasing 0.2% in August following larger increases in June (+0.3%) and July (+0.4%). Growth in shelter costs continues to be a major driver of core inflation. Price increases were also seen in apparel, tobacco, alcohol, medical care commodities and non-energy services.

After falling 5.6% in July, the price of airline tickets continued to decline in August, down 3.1% for the month. Other factors keeping seasonally adjusted inflation below zero in August include declines in the prices of used cars and trucks (-0.4%), household furnishings (-0.3%) and recreation (-0.1%).

Annual Inflation

Year over year, the all items index increased 0.2% in August. The number, which has been rising since April, was also 0.2% in July. Food and shelter costs were significantly higher over both annual periods. Prior to seasonal adjustment, the price of food was up 1.6% for the year ending in August, the same as the year ending in July. Shelter costs were 3.1% higher for the 12-month period. The indexes for transportation, medical care services and non-energy services were all higher, up 2.1%, 2.2% and 2.6% respectively.

Despite higher prices in many parts of the economy, sever declines in energy prices for the year ending in August kept inflation tame. The energy index fell 15% for the year ending in August including declines in all major components. The most drastic fall was in the price of fuel oil, down 34.6% for the year. The gas index was down 23.3% and piped gas services were 11.5% cheaper for the year.

The index for all items less food and energy was in line with July, rising 1.8% over both 12-month periods. August marks the fifth time in 6 months that the 12-month change in core inflation was 1.8 percent. Annual core inflation was driven by higher prices for shelter, health care, new vehicles and recreation. While apparel, used vehicles, household goods and air travel have all posted 12-month price declines.

Outlook for the Fed

A high inflation number would have been welcome news for the Federal Reserve as it would have been a missing piece pointing to a strengthening economy and giving them the opportunity to raise interest rates for the first time since 2006. Most other U.S. economic data is more positive. Unemployment was down in August for the third consecutive month and hovering around what the Fed considers ‘full employment‘ at 5.1%. However, with inflation quite stagnant, a rate hike is unlikely this month

Emerging markets, struggling since the recent downturn in China, would be vulnerable to a U.S. rate hike. Higher rates would strengthen the U.S. dollar. Emerging markets, with U.S. dollar denominated debt would struggle to repay loans. Markets are currently pricing in a U.S. rate hike in December. Today’s inflation data was inline with expectations and will not change the market’s expectations regarding the timing of rate increases.

July’s Weak Inflation Numbers Mean More Uncertainty Around September Rate Hike

On Wednesday, the Bureau of Labor Statistics released inflation data for July that was slightly below expectations. For the month, the headline number or Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1% compared to a median estimate of 0.2% for analysts polled by Bloomberg.

For the 12-month period ending in July, inflation was only 0.2%. This number includes consistent declines in monthly CPI numbers for October 2014 through January 2015.  Year over year, core inflation, which excludes food and energy, climbed 1.8%. This is exactly in line with expectations and equal to the core annual inflation number reported four of the past five months.

July’s CPI numbers follow increases of 0.4% and 0.3% in May and June respectively and  point to a loss of momentum. Sluggish inflation means the Federal Reserve may be hesitant to raise rates in September. The Fed’s key interest rate has hovered around zero since December 2008 but a series of rate hikes has been widely anticipated to start as early as next month. Weak inflation coinciding with global economic troubles could indicate that the US economy is not ready for higher interest rates.

Crude Oil Prices Tumble in July

The Energy index fell 14.8% for the year ending in July, despite an increase of 0.1% in July. Crude Oil went from around $58/barrel to below $46/barrel in the month of July alone; such low prices have not been seen since 2009. However, gasoline prices edged higher by 0.9% in July following increases of 3.4% in June and 10.4% in May. Year over year, the gasoline index has still slid 22.3% due to the sharp declines in the second half of 2014. Aside from gasoline, all other major components of the energy index fell in July. Year over year, all components of the energy index are significantly lower with fuel oil posting the largest 12-month decline, down 29.7%.

oil jpeg

 

Declining oil prices have sparked competition among airlines and fares fell a staggering 5.6% in the month of July. Low fuel costs have slowly filtered through to consumers resulting in the largest monthly decline in airline tickets in nearly 10 years. Economists do not expect prices to remain low for long.

Food and Housing Costs on the Rise While Wages Remain Stagnant

The food index climbed 1.6% for the year ending in July, including a 0.2% rise in July alone. All six major grocery store indexes were higher for the month, led by dairy products, up 0.8%. The price of fruits and vegetables rose 0.3% in July. The year ending July saw drastic increases in the price of eggs (24.9%) and beef (10.0%). Compared to a year earlier, food at home is 0.9% more expensive and food away from home is costs 2.7% more

Shelter costs are up significantly (3.1%) year over year. In July, shelter costs posted their largest monthly gain (0.4%) since February 2007. This is largely due to higher rental costs as available housing continues to dwindle. Vacancy rates for rental units are near their 22-year low. The graph below shows that this trend has been consistent since 2010. The problem, according to Diane Swonk, chief economist at Mesirow Financial in Chicago is that “rents are surging and in the face of stagnant wages [which] leaves less for consumers to spend elsewhere in the economy.”

shelter

 

The July jobs report showed a small decline in unemployment, down a marginal 0.02% to 5.26%, which is a 7-year low. Employment growth has been healthy and consistent but wage growth has lagged previous economic recoveries. David Kelly at JP Morgan blames low headline inflation numbers, among other factors, for lacklustre wage growth.

Outlook for the Federal Reserve

Growing concern over the health of the global economy could delay or slow the pace of interest rate hikes at the Federal Reserve. China’s surprise devaluation of the yuan should be a major concern for the US economy. Other emerging markets could potentially follow suit if they wish to remain competitive with China. This could spur global deflation. Import prices will certainly fall in the US. Combined this with drastically dwindling commodity prices and a strong dollar and there is little to support price growth. Although the Fed has stated that they may still raise rates despite low inflation, it is a key factor they will need to consider. Raising rates in a deflationary environment is unlikely.

Yuan Devaluation Spells Trouble Ahead

yuan
The PBOC stunned world markets this week with a series of consecutive devaluations of the Yuan, dropping nearly 5 percent against the US dollar and poised to weaken even further in the days and weeks ahead. The Yuan devaluation is just the latest in long list of policy responses to help stimulate China’s slowing economy, although this latest move is likely to have broad reaching implications for the rest of the world. Chinese monetary authorities increased the currency’s reference rate against the dollar by 1.9% without warning in the early hours of Tuesday morning, and have continued to intervene in the broader currency markets ever since. The biggest move in the CNY prior to Tuesday’s devaluation was a meager 0.15% as the currency remained tightly controlled by the authorities, emphasising just how shocking the 1.9% move on Tuesday has been for investors’ collective psyche. Chinese officials have been justifying the devaluation by pointing to the strength in the US dollar over the past year which has caused the Yuan to appreciate significantly against the Euro and British pound in particular. While the Chinese argument has some merits, many analysts are viewing the move as an escalation of the “beggar thy neighbor” currency wars which have been raging throughout the world since the onset of the financial crisis in 2008. The obvious question world markets are currently having to contend with now that China has officially entered the global currency war, what implications will this latest move have for broader markets including China’s immediate neighbors, the US dollar, and Federal Reserve policy going forward?

Emerging Markets Set to Follow China’s Lead

One of the biggest threats to emerge from the recent Yuan devaluation is a potential full blown currency crisis in emerging world FX rates. Prior to China’s devaluation, many of these countries were already struggling with weak currencies and mounting current account deficit issues. Collapsing commodity prices have placed a significant strain on these countries budgets, and now they face the unenviable task of having to devalue their currencies further in order to keep in step with China. The risk of contagion from this sort of mass currency intervention is clear. Many corporates in Asia and other emerging markets have been borrowing US dollars since the 2008 crisis due to the zero percent interest rates and widespread belief that their own domestic currencies would continue to appreciate against the dollar. This type of behavior should sound familiar, it is the exact same line of thinking which sparked the Asian financial crisis of the late 1990s.debt Faced with plunging domestic currencies, the cost of servicing US dollar debt is set to climb sharply for these corporates. Stephen Jen, a prominent analyst who called the Asian currency crisis in the 1990s while working for Morgan Stanley predicts emerging market currencies could fall a further 30 to 50 percent from current levels in response to the declining Yuan. The implications of such a move on these economies would be devastating – a toxic mixture of inflation and widespread corporate insolvency. Many of these nations have been a key driver of global growth in recent years, so weakness in their economies are likely to be felt on a worldwide scale

Where Does the Federal Reserve Go From Here?

Ongoing weakness in China and emerging markets at large are likely to be felt more acutely in developed economies in the months ahead. The biggest concern amongst many analysts is the potential for a return to the deflationary pressures which dogged sentiment in the US economy in the early part of 2015. These concerns are warranted. Commodity prices have continued to collapse in the past few weeks with the price of crude oil in particular hovering dangerously around the $40 per barrel mark, the lowest price in over 6 years. The low price of oil and energy related costs will have significant ramifications for both the CPI and PPI data in the months ahead, and it seems increasingly likely that a return to negative readings for CPI in particular is a real probability for the August and September data which should be released in the fourth quarter. Armed with the knowledge that these types of headwinds are in the post for the US economy, it seems increasingly unlikely that the Fed will lose its nerve to begin raising rates at its upcoming September meeting. The more cynical among us could even argue that China’s devaluation has been a dream come true for the Fed as it gives it enough cover to delay raising rates due to “external” factors and opens the door for more QE. And more QE at the end of the day is what every wants. The government wants it, the market wants it, emerging markets want it, and it looks increasingly likely that they will get it in the months ahead. The worrying element to all of this is that the current weakness across world markets is systemic – it feels far more dangerous than 2008 and we are now on the eve of a bigger crisis knowing full well that the world’s central banks have no credible policy response to deal with it.