One thing dragging down inflation might finally start to disappear

Last year's strong dollar dragged down inflation and restrained import prices.

In fact, the dollar pushed core PCE down by around 0.3 percentage points in 2015, according to an analysis done by Bank of America Merril Lynch researchers.

But that effect may soon start to dwindle.

Since the end of January 2016, the dollar has weakened by about 4.7%. And at the same time, import prices have started to stabilize.

"Given that the pace of [the dollar's] appreciation should moderate this year - our FX strategists anticipate a 6.0% year-over-year clip by the end of 2016 - the dollar drag is likely set to fade, allowing for a gradual uptrend in core PCE inflation," argued Bank of America Merrill Lynch's Emanuella Enenajor and Alexander Lin in a recent note to clients.

The team's baseline forecast is 1.7% yoy core PCE inflation by the fourth quarter in 2016 and 1.9% yoy inflation by the fourth quarter in 2017. However, the team also argued that if there's a 10% drop yoy in the dollar in the fourth quarter 2016, and then it flattens, it could push PCE inflation to 2.0% by the fourth quarter in 2016.

Notably, BAML's idea is already starting to show in some items that are highly dollar-sensitive and have high import content, including jewelry, appliances, and motor parts, according to Enenajor and Lin.

So, taking it a step further, the BAML team put all these items together, totaling about 9% of the core PCE index, and used their relative weights to create a dollar sensitive inflation index, which can be seen in the chart to the right.

The team points out that the index has "improved sharply" since autumn 2015 when the dollar began to moderate.

"Continued gains would be a sign that the dollar's headwind is quickly fading from the data," suggested Enenajor and Lin.

In short, the duo suggests that the dollar may soon be shifting "from foe to friend."

"Core PCE has been stubbornly weak throughout the recovery, and we continue to see inflation below 2% this year and next. But as import prices improve on the back of an easing dollar drag, core inflation is set to edge higher by a few tenths of a percent," argued Bank of America Merrill Lynch's Emanuella Enenajor and Alexander Lin in a recent note to clients.

"For now, the Fed seems skeptical - a factor that makes us even more convinced that inflation will tick higher as Fed caution could trigger dollar weakness."

The dollar index is weaker by 0.3% at 94.79 as of 10:41 a.m. EST.

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