The US gambles with the dollar

Jerome Powell's recent announcement of the change in Fed policy to target inflation at 2% on average was not a surprise. Powell has previously tried to communicate that the Fed is indifferent between missing on the upside as they are missing on the downside. This policy statement tries to build on those previous statements. The Fed believes they can influence inflation expectations and in turn create inflation. Powell said nothing about whether they will use additional stimulus preferring to maintain the stance they will use all available tools.

Powell also communicated that they did not believe there should be a limit on their aim to increase employment; i.e. for now at least, the Phillips Curve is dead.

There were 2 important counterbalances to the statement. The first being a restatement they would not allow inflation to run out of control and would come down hard on any sign it was. Secondly, and most important, they gave no guidance on what level they believe is acceptable to the upper level. Purposefully, the average inflation target will not follow any formula but will be based on circumstance.

This is I believe necessary. Giving forward guidance which is formulaic will have a high probability you will break such guidance, lose credibility and set yourself back in your aim to control economic actions and inflation. However, it also means the change in policy will have less impact.

Essentially, the Fed has communicated it is willing to tolerate higher inflation but is not willing to lose control; i.e. they will take a greater risk but not too much that inflation would risk ever being out of control. It has not stated how high it will let treasury yields rise. I expect the 10y will oscillate between 50-100bps until the Fed adds clarity at the mid-September FOMC meeting.

Meanwhile, the US dollar continues its retreat. The Fed and Trump's government, for now at least, seem content. This will make inflation easier to achieve and encourage net exports.

For developed nations for whom centuries of stable government has earned the trust of investors and trading partners, a stable currency and hence controlled inflation is almost taken for granted. Developing nations on the other hand need to work hard to ensure they earn and maintain trust. They always must consider the risk that confidence in the incumbent government will be lost and so in turn capital flight ensues and the currency free falls which ignites inflation pressures.

In the US, the Fed has re-iterated their 'whatever it takes' stance and communicated an increase tolerance for inflation. Over the next few months, Trump will ignite his supporters and model Biden as a destabilising threat to national security. We've seen one death this weekend as Trump supporters clash. Trump's response was to Tweet, "Law and Order".

If the dollar is allowed to continue its decline, commodities continue to rally and the election run-up gets more heated on the streets, yields could spike. But these spikes will not be a sign of positive future growth, rather a sign the economy is risking the confidence of its investors and trading partners. If that gamble does not pay off, it will play into the hands of China and Europe, and their currencies as reserve currencies in-waiting.

Leave a Reply