FXStreet (Delhi) – Research Team at Societe Generale, suggests that with a continuous improvement in the US labour market, it is clearly mild inflation which prevented an earlier liftoff. Key Quotes “The Fed will remain data dependant, but the market is now likely to pay even greater attention to inflation prints. Our Chief US economist analyses that the Fed would diverge from the roughly one hike per quarter pace if inflation disappoints relative to its forecast.” “Slow price dynamics are perceived as “transitory” and the FOMC forecasts the core PCE will increase at 1.6% at the end of 2016. Among other factors, dollar strength will require the starting cycle be slow. Even if this cycle is not as regular as the previous ones, which saw a single hike at each meeting, inflation forecasts from the board provide good readability in its reaction function, so markets are less likely to be caught short by surprising policy decisions. That should prevent volatility from spiking.” “Indeed, there is a strong and inverse connection between inflation expectations and EUR/USD volatility. When the US breakeven rate goes up, volatility tends to fall. Rising expectations are generally compatible with better growth prospects and risk appetite on markets. Even if it fuels the term premium in the US yields curve and tends to increase rates volatility, the vega in FX space is unlikely to decisively outperform on the back of Fed tightening.” “However, when the 5Y breakeven trades above 1% (it is currently at 1.2%), volatility ranges tend to be wide even if average volatility is lower. The negative link between EUR/USD volatility and core PCE has been very tight ahead of both the previous and the current Fed cycles. Volatility did not trade at high levels but nonetheless experienced significant gyrations.” “If the PCE/volatility relationship prevailing since 2013 holds, a rise to 1.6% would lower the EUR/USD 3% implied volatility to 6%, from a current 9.9%. Such a projection is not a very realistic way to fix a target, but if the Fed is correct in being confident that inflation will pick up, EUR/USD volatility should stay under relative pressure. However, volatility likely will become less stable if inflation expectations gain momentum.” For more information, read our latest forex news.