A key focus of the market is the possibility that the Federal Reserve will need to come in and further ease policy in order to help the US recovery. Recent data has been slightly supportive of a recovery that is perhaps picking up some momentum, but the troubles in Europe have the potential to undermine growth. The Fed likely would need to see deterioration in the macro data before it decides to undertake further easing.

The scope for the Federal Reserve to undertake further easing would depend on how inflation evolves over the next few months, and we get our latest reading on consumer prices in the Wednesday (11/15/11 at 8:30AM ET) trading session.

Headline Annual CPI Expected to Ease, but Core CPI to Rise to 2.1%

First let's look at the broader picture by looking at the annual rate of inflation.

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Looking at a chart above we see a steady climb in prices throughout this year, with the headline rate approaching 4% (it was 3.9% in September). The core CPI - which is the rate that is monitored more closely by the central bank as it excludes the volatile items food and energy - came in at 2% in September. That is generally consistent with the target of the central bank.

The expectation for the headline rate is for prices to ease to 3.7% from 3.9% in September, with the core annual CPI up 2.1% from 2% and September.

Monthly Rate Expected to be Flat

In monthly terms, consumer prices were up 0.3% in September with the core rate showing a tepid 0.1% rise.

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We can see from the chart above that headline inflation rebounded from a dip into negative territory in the summer, while the core rate - which had been running at modest levels over the previous seven months - slowed to a 0.1% rate in September.

The forecast is for even tamer inflation in October. While the core rate is again expected to show a 0.1% increase, the headline rate is expected to be flat.

Scenarios and Implications

While Europe continues to dominate headlines the inflation picture in the US, it will be important, as we mentioned at the top. to consider the implications of inflation data on the Federal Reserve.

Status Quo: If we see the expected consensus forecast coming to fruition it shows us that inflationary pressures have receded as we move towards the end of the year. That would give some scope for the Federal Reserve to undertake further stimulus though it would like to see a cooling in the headline rate and core CPI to remain at or below 2%.

Quantitative easing is appropriate policy when there is fear of deflation, and the coincident data that we are looking at does not suggest the prospect of that currently. A flat reading in the monthly headline index would leave the Fed some wiggle room, but with oil prices rising in the last month, and extending their gains in November, we can expect to see the headline rate be pushed up in the following months. The focus therefore will be on what we get from the core reading going forward.

Weaker Than Expected: If we see inflation coming in weaker than expected - a negative reading in the headline figure and a drop in the core annual rates - that would give the FOMC more leeway to undertake looser monetary policy if the economic situation deteriorates.

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Such a development would be seen as a dollar negative. The central bank has for the most part underperformed its employment mandate and as long as labor market situation continues to show persistently high unemployment rate the Fed may be biased to do more.

While this may not necessarily mean further quantitative easing, other steps the Federal Reserve could take include giving more specific targets of economic data at which it would raise interest rates. For example the Chicago Fed President Evans has stated that as long as core inflation remains under 3% and until the unemployment rate falls below 7% the Fed should make an explicit guarantee that it would keep interest rates at their record lows.

In his press conference following the latest FOMC decision we heard Bernanke say that the Federal Reserve is willing to buy more mortgage-backed securities, as well as government debt, if necessary.

Stronger Than Expected: If we get a stronger-than-expected reading from the US inflation data it works in the opposite direction, limiting the scope of the Federal Reserve in undertaking further loosening of monetary policy and therefore would be a positive for the US dollar. The US economy did pick up a little bit of pace recently, following an uncertain summer in which economic data had pointed to the possibility of a double dip recession. We'll see if this uptick in the macro data filters down into the ability of stores to raise prices more than expected.

- Nick Nasad is the Chief Market Analyst at FXTimes - provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.