The FDI put in a bottom back in January and has been appreciating since. The first signs of this increased purchasing power of the dollar appeared in the asset markets. As we noted earlier, stock prices peaked on January 26 and have been in a bear market since. Copper prices have generally been weak as well and housing prices have been losing their upward momentum. Then more recently oil prices have joined in on the fun having declined more than 20% in just the past few weeks.
But wait you say … isn’t inflation rising according to the CPI, PCE deflator, and other official measures of prices? Sure, but they’re not reliable. Yet don’t thousands of economists use these gauges to measure inflation?
If a thousand economists were marching off the edge of a cliff, would you follow them? At Financology we think these official measures are misleading. They are lagging indicators. We predict that unless the upward trend in the dollar seen in the FDI since January soon reverses, these lagging proxies for inflation will begin to soften and even go into decline.
To be clear, I’m not forecasting deflation. Deflation is already here.
The real question is how much further it goes. I see it as a collision of the Fed’s attempt to normalize monetary policy with the massive buildup of debt spawned by its having pursued abnormal monetary policy too long. The Fed has painted itself into a corner and can’t fully normalize policy after erring in such a big way without creating big problems. The best it could do at this point would be to bring its Treasury security sales to a halt. It may be possible to continue gradual rate increases or at least avoid premature rate cuts. In any case I agree with Fed leadership that rate normalization should be a top priority, but see no reason why quantitative policy can’t be more flexible.
Big picture: Over the past three decades, the Fed has run into a rut of ratcheting rates lower each cycle in an attempt to stimulate the economy. It’s plainly unsustainable. It needs to break the cycle of dependence on ever lower interest rates and quantitative policy is the only way out.