See the latest Australian dollar analysis here:
Lombard with the note:
Last Friday, Fed Vice Chair Richard Clarida reasserted the Fed’s declaration of independence of monetary policy from what other central banks are doing. In his speech “Perspectives on Global Monetary Policy Coordination, Cooperation, and Correlation.” he said — “Today I will make a somewhat different, and less often discussed, case questioning formal global monetary policy cooperation—that, in practice, adopting it could plausibly erode central bank credibility and public support for central bank instrument independence.” Clarida is Powell’s economics “consigliere”, much like Fischer was for Yellen, and this means his words matter.
The timing of his message is no accident when the Fed is readying to speed up the pace of taper to underpin the market pricing three 25bp hikes in 2022, beginning in June. There is concern among the world’s central banks about how to react to the US once again setting out to tighten global financial conditions. This concern is particularly acute among emerging market bankers.. The impact of US monetary policy on emerging markets is something Clarida readily admits in his speech – “U.S. policy rate changes attributed to U.S. inflationary pressures trigger more substantial spill overs to EM financial conditions . . . with more vulnerable EM countries experiencing larger spill overs from U.S. monetary policy.” His answer to this, other than that public support for central bank independence demands a central bank reacting to domestic concerns, is that the direction of causality runs in both directions. He cites numerous examples, beginning with the Mexican peso crisis of 94-95.
There are 1282 words left in this subscriber-only article.
Get your first month for $1
Most relevant to the potential course of Fed policy in 2022 is Chinas current problems, and Clarida made certain to bring up China’s devaluation and capital flight episode of 2015/16.
Those events disrupted global financial markets, caused the US equity market to drop, and the dollar to appreciate (safe-haven inflows). Recalling the Fed’s policy response, he said– “Federal
Reserve statements and transcripts from that time indicate that concerns about these developments and their effect on the U.S. economy were a factor that contributed to the delay in implementing previously signalled policy rate increases.”
The conduit of monetary policy today runs through the dollar and the equity markets. A higher funds rate slowing the pace of borrowing is a quaint notion learned in the Money & Banking classes we took in college. In this era of massive reserves created by the Fed to purchase UST and then keeping those reserves on deposit by paying interest to banks, a higher funds rate boosts bank earnings rather than raise their marginal cost of funding. Second, the current run of inflation has been created by a confluence of factors, including fiscal transfers and a too strong equity market, but not outsized leverage funding purchases.
Third, as I have written, the “secret sauce” of low US inflation has been through the goods sector (ex food and energy) and this has been, in effect, purchased with real rates being set to sustain a strong dollar despite sizable trade imbalances with Asian exporters. The cost has been the hollowing out of the tradeable goods and service sectors of the US economy.
The inflation risk for 2022 is that with the lid off goods prices and a strong profit year in 2021, the nation is set for broad wage gains in the coming year – gains to date that have gone where workers are in short supply. The only way for the Fed to counter this inflation, without damaging the recovery and, more importantly, the equity market, is to ramp up the dollar.
Rhetoric about raising the funds rate, supported by accelerating the taper, accomplishes this goal. Term yields will not be boosted by the taper because Fed demand is dropping slower than the pace of Treasury financing, thereby leaving the fundamental supply/demand imbalance in place. To the extent Fed purchasing is missed, the stronger dollar boosts the trade deficit and this will, in turn, increase the inflow of foreign capital to buy US assets.
With lower import prices the Fed’s only route to take inflation off the boil, China exporting deflation is how the Fed’s hikes in 2022 are limited to one (our call). By recounting the Fed’s reaction to China’s 2015/16 episode, Clarida is telling us what we have been saying. China matters a lot to the 2022 outcome, and the downside risk is greater than what markets are pricing.
Last, but not least, while ramping the dollar is the only route for the Fed to counter current inflationary risks, a strong dollar policy is not aligned with Administration aims (Biden’s or Trump’s, for that matter). The political imperative is to regain production of goods and services lost to offshoring and an overvalued dollar works against this imperative. Once the current inflation “scare” has been worked through, and we believe it will, we fully expect the Fed to drop back to policy that keeps from supporting a too strong dollar. This means a cycle with higher inflation (2.5%-3.0%) rather than 1.5%-2.0%, tolerated by the Fed if it is stable, which, in turn, will boost measured inflation.
As for Clarida, he is gone by the end of January, and Powell’s term is up in February. Regardless of whether Powell is reappointed, his “consiglieri” will be someone else. The coming changes to the FOMC will put policy in line with what the Administration wants – low rates and a not strong dollar. To be fair, Trump wanted the same when he was continually criticizing the Fed for raising rates in 2017 and especially 2018 – he was right.