PMI Data Will Show Currency Pressures – US Dollar Policy in Focus

                                                          Tim Clayton

The impact of currency trends on the global manufacturing sector will be an important underlying factor in the first week of 2017 and shed light on potential monetary policy trends during the first half of the year. Any evidence of deflationary pressures in the US from dollar strength would make it more difficult for the Fed to tighten policy and increase the risk that the strong dollar policy would be jettisoned.

The Eurozone manufacturing PMI strengthened to the strongest level for over five years at 54.9 for December with companies reporting new growth in export orders at the second-fastest pace since April 2011 with the weaker Euro an important factor in boosting competitiveness and incoming orders.

Further strength in orders and inflation would increase pressure for the ECB to remove policy accommodation during 2017.

Currency factors will also have an important impact in the UK and US manufacturing PMI data this week and will have a significant impact in calibrating the likely central bank monetary responses over the next few months.

The UK PMI manufacturing index dipped sharply to a low of 48.3 following the June referendum vote, the weakest level for over four years before recovering sharply to a high of 55.5. Since then, the index has faded to 53.4 for the November data with little changed expected for December.

Sterling remains much more competitive in global markets, especially in the US economy and this will continue to have a positive impact on the export sector.

Relative strength in exports will also be a crucial factor in underpinning the overall manufacturing sector. The key element to watch in the data is whether manufacturers are strong enough and have sufficient capacity to take advantage of Sterling weakness to boost output and support the wider economy.

Inevitably, there will be fears that capacity constraints will limit output and that companies will also take advantage of Sterling weakness to raise prices rather than look to boost output and market share.

The inflationary data within the PMI data will also be important as the Bank of England is forced to balance the trade-off between growth and inflation. A further strong increase in inflationary pressures and relatively firm output would push the Bank of England towards a tighter monetary policy.

Stronger inflation pressures and relatively weak output would tend to have a more neutral impact, while evidence of easing inflationary pressures and weak growth would shift the central bank towards policy easing.

In contrast, the US manufacturing sector faces the opposite situation with the dollar trading close to a 14-year high on a trade-weighted basis.

Domestic demand will tend to dominate the manufacturing data, but the export component will still be very important and will be watched closely in the ISM data.

After a brief dip below 50.0 for September, the ISM manufacturing index strengthened to a 5-month high at 53.2 for November with markets expecting a further advance for the December data.

The strong dollar will inevitably have some adverse impact on exports even though the main impact of the latest currency surge will not show up until later in 2017.

The Federal Reserve will be much less comfortable over economic developments if exports appear to be under sustained pressure. Pricing evidence in the data will also have an important impact with dollar strength having a significant impact in holding down inflation.

The balance between domestic and imported inflation is likely to have a crucial policy impact over the next few months. If dollar strength appears to be having relatively little impact and inflation overall is strengthening, the Fed will look for further rate hikes. In contrast, evidence that currency strength and competitive pressures are having a big impact in holding down prices, there will be a potentially substantial impact on Fed policy with the FOMC much more reluctant to raise interest rates.

Evidence of a damaging impact from on US manufacturing from a strong dollar would also make it much more likely that the President-elect Trump and the new Administration would push for a weaker global dollar given that US currency strength will have a short-term impact in undermining US manufacturing and working completely against its policy objectives