Friday, September 16, 2022

The dollar's strength is telling Powell to chill

Here's my understanding of the current collective wisdom of the market:

  • Both inflation and the US economy are "running hot."
  • The Fed needs to boost rates dramatically to slow the economy and bring down inflation.
  • The US economy is very likely to suffer another recession as a result.
  • The outlook is not so terrible, however, since once it is clear that inflation is under control the Fed will be able to lower rates.
  • The Fed will hike the funds rate to a peak of 4.5% over the next 6-7 months, then cut rates to 3.75% by mid-2024.
  • Inflation, currently running about 8%, will fall back to 2% or so by the end of next year

As I've pointed out in previous posts, however, the Fed and the market are ignoring some very obvious signs which strongly suggest that the Fed's best course of action is to NOT follow this script: 1) the dollar is extremely strong, 2) commodity prices are falling, 3) the M2 money supply has not grown at all for the past 6 months because the federal government is no longer sending Covid stimulus checks to the public, 4) measured inflation is already declining, and 5) inflation expectations have declined significantly, down 120 bps since early March (inflation expectations peaked at 3.69% and are now 2.49%). Moreover, yesterday FedEx shocked the market by suggesting that demand has all but collapsed. All of this suggests money is already tight enough to impact the economy, and more could be destructive.

The market is telegraphing that what the Fed is planning to do is potentially destructive to the economy. Why does the Fed still think the only way to lower inflation is to undermine the economy? That's Phillips Curve thinking, and it has been debunked countless times. Growth doesn't cause inflation. Too much money is the culprit (i.e., money that exceeds the demand for it). What the Fed needs to do in cases like today's is to 1) bolster the demand for money by raising interest rates (they have accomplished that goal already!), and 2) reduce the unwanted supply of money (something that is well underway since the M2 money supply stopped growing long ago). 

If the Fed were to follow the market's script, we could see real problems develop. The US economy could weaken dramatically, creating a double whammy for the working class: rising unemployment on top of already-declining real wages. This is totally unnecessary.

I have to believe they won't follow through on their hiking hysteria. And that should prove very positive for the economy and the market.

A few charts to illustrate the situation with the dollar:

Chart #1

Chart #1 shows two measures of the trade-weighted, inflation-adjusted value of the dollar. Each uses a different basket of currencies: major currencies vs. most currencies. The dollar today is within inches of its all-time highs according to these measures. It's not healthy for the dollar to be this strong, because it is symptomatic of very restrictive monetary policy. Sure, European currencies are weak because their economies are at risk with the Ukraine-Russia conflict. It's logical that Europeans would rather hold dollars, and the Japanese too (the yen is plunging). That's fine, but the Fed should figure this into its calculations: increased demand for dollars with the dollar at all-time highs calls for looser, not more restrictive Fed policy.

Chart #2

Chart #2 compares the price of gold with the real yield on 5-yr TIPS. Real yields are a direct measure of the relative tightness or easiness of Fed policy. The Fed tightens by causing real yields to rise (shown here by a drop in the blue line), and tight monetary policy from the Fed makes gold less attractive since it yields nothing in comparison. Tight money has always caused gold prices to decline, while easy policy feeds into rising gold prices. 

Chart #3

Chart #3 compares real and nominal yields on 5-yr Treasuries, with the difference being the market's expectation for what CPI inflation will average over the next 5 years. Inflation expectations have averaged a very modest 2.5% for more than a year, despite the big increase in inflation we've lived through. This can only mean that the market realizes that the current inflation is a one-off phenomenon that is very likely to reverse in the near future. 

Note also that the last time TIPS yields were as high as they are today was in late 2018. Check out my posts from back then, here and here. This episode was reminiscent of today, in that both times the Fed was hell-bent on tightening policy at a time when the market was warning that a tightening was not needed—and stocks crashed both times. The Fed finally reversed course in early 2019, that unleashed the economy. We can only hope they will do this again!

Chart #4

Chart #4 compares the price of gold to the value of the dollar (inverted on the chart). A strong dollar has always been bad for gold, and a weak dollar good for gold. If the Fed hikes rates aggressively from here the outlook for gold and many other commodities looks quite bleak.

Chairman Powell, you need to take a chill pill, and the sooner the better. Please don't give us aggressive tightening rhetoric at next week's FOMC meeting. 


Benjamin Cole said...

I think Scott Grannis is right.

An oddity of central banks is that they always seem late--not just in the US, but Australia, the ECB and Reserve Bank of India, the Bank of Canada and so on.

It just may be the way large organizations are (anyone who has worked in a large organization knows the drill).

Powell will probably talk tough this coming week, and raise rates 0.75%. But we may be at "one (more)and done."

BTW, US dollar up 24% against the yen since the start of the year.

Here is an interesting discussion of the Fed's balance sheet. I wonder also if the Fed needs to reduce its balance sheet.

Tom L said...

Scott do you favor the TIPS ETF with yields at their current level - bullish on $TIPS

Thanks, always appreciate your analysis!!


Shawkat Abdelhamid said...

I can foretell that won't be everytime scenario, inflation will go up rapidly once 2023 door is opened because energy prices expected to reach 150$ a barrel in winter as JP Morgan told. However, I can expect oil to reach 250$ this will bring inflation to more than 15% and this will be the first time in America and Europe which will create the worst world recession and worst world War 3.

Salmo Trutta said...

re: "It's not healthy for the dollar to be this strong,"

The E-$ market is contracting. All prudential reserves systems have heretofore "come a cropper".

Shawkat Abdelhamid said...

I expect inflation to continue for the next 5 years at least, the fed will have no choice but a double digit interest rate. Everybody should be ready fir this with crazy Putin pouring oil on fire.

Salmo Trutta said...

My “unified theory” is based upon American, Yale Professor Irving Fisher – 1920 2nd edition: “The Purchasing Power of Money”:

“If the principles here advocated are correct, the purchasing
power of money — or its reciprocal, the level of prices — depends exclusively on five definite factors:
(1) the volume of money in circulation;
(2) its velocity of circulation;
(3) the volume of bank deposits subject to check;
(4) its velocity; and
(5) the volume of trade.

“Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an “equation of exchange.”

“In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an EXACT SCIENCE, capable of precise formulation, demonstration, and statistical verification.”

The distributed lag effect of money flows, the volume and velocity of money, are mathematical constants.

Salmo Trutta said...

“Base” velocity (clearing balance velocity) is higher than ever. In the month June 2022, 17,387,933 million Fedwire transfers totaling $90.662,186 trillion were processed.

McKibbinUSA said...

The Fed will conjure unlimited dollars to save the dollar from itself -- that's what the Fed always does -- heck, it always worked before...

Scott Grannis said...

Tom L: re the TIP ETF. I like this fund a lot. You get 1.1% real interest guaranteed, plus whatever the rate of CPI inflation turns out to be. The fund drops in price if real yields rise, but they have already risen more than 3 percentage points from the low (from -2% to +1%). Real yields could go higher if the economy proves exceptionally strong, but that seems quite unlikely. If inflation rises and the economy craps out, this fund could deliver a very handsome return.

Unknown said...

Ĝ§According to Mr. Pavel's words, two very important things have been almost ignored:
1 Energy discussion
2 rush to control inflation
Since inflation shows itself with almost a delay, all this rush to increase the interest rate shows another path for the economy, which I call economic war.
And the thing that the American economy has not paid attention to is the energy issue, which can become a big problem due to the upcoming war and the lack of many resources and the disruption in the supply chain.
And I also agree with you that Mr. Powell should be calmer, otherwise we will see higher inflation.

Frozen in the North said...


If one follows your argument, then it means that the "natural" interest rate is near zero. The distinction then becomes between types of financial assets, where debt instruments pay next to no yield and stocks pay no dividends (but via the increase in the value of shares investors see the appreciation of their assets).

It's an interesting position because it means that the natural rate of return on financial assets is zero. I think that's what you mean but I am not entirely certain...


Scott Grannis said...

Frozen, re the "natural" interest rate. I had a post on the natural rate ( Among other things, I noted that "the natural rate is the real interest rate consistent with output equaling potential and stable inflation. In short, it's one way of estimating what the real Fed funds rate should be if the economy is operating at or near its potential and inflation is stable." It's generally felt that a stronger economy is consistent with a rising natural rate and vice versa. The natural rate is also a risk-free rate, which means that riskier instruments (e.g., corporate bonds) would naturally have a higher yield. Stock dividends would also be higher than the natural rate.

marcusbalbus said...

dr pangloss is an inflationist. its clear from all his writings over the years. he explains not why he is, why "higher markets" are a good for all.

Scott Grannis said...

Today the FOMC was a bit more aggressive than the market expected. That’s unfortunate, but not the first time that Powell has erred on the side of tightness. The last time he did, in late 2018, he corrected a month or so later and markets settled down and the economy prospered. I suspect the same thing will happen again.