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.
4 thoughts on “A Whiff of Deflation”
1. a quote you’d find useful- george soros: i’m not predicting; i’m observing.
2. how much of the rise in the fdi is from financial asset markets selling off?
Apt quote, JK!
I’d almost look at it the other way around … the selloff in the financial markets is a manifestation of the rise in the value of the dollar. If that selloff were the only or even the main phenomenon, I’d be more tempted to say it contributed to the FDI. But we’ve also seen falling prices in the commodity markets … real goods. As you know gold prices sold off for much of the year. Copper prices are down, and lately oil has notably joined in. When you see such broad price declines you have to strongly suspect it’s a phenomenon of a rise in the unit you’re doing the measuring in. The alternative is to believe there was some spooky metaphysical conspiracy between such disparate entities as financial assets and physical commodities as to say “…all together now…”!
gary shilling and a number of other observers are predicting a continued rise in the usd, lasting years and perhaps revisiting the highs of 1985. this prediction appears to be based on interest rate differentials; the fed’s qt as well as rising deficits squeezing the treasury market; repatriation of dollars held overseas; increasing frictions in foreign trade and inshoring of supply chains; and santiago capital’s “dollar milkshake” theory where foreign cb’s ongoing accomodation flows to the u.s. since only the u.s. is tightening. the huge increase in treasury supply and the increasing absence of foreign buyers* are all showing up in increasingly poor bid/cover ratios at treasury auctions, which in turn points to still higher rates ahead,
[*note that the current cost of currency hedging means that it is not profitable for foreign investors to move into dollar bonds unless they are willing to carry currency risk as well. also china in particular said some years ago that it had no desire to increase its holdings of treasury bond.]
this scenario reminds me of a comment by marc faber long ago, to the effect that the dollar will be the last fiat currency to be shredded. at that point one wants real assets in general, and gold in particular, but that point might be years down the road.
have any thoughts on the dollar relative to other currencies?
The first thing that strikes me about the dollar versus other currencies is that it’s been giving the same message as the FDI. That’s not necessarily a given … it would be plenty plausible that the other currencies by which the dollar is being measured in conventional forex-based dollar indices are merely declining themselves and leading to the appearance of an appreciating dollar in comparison. Especially given that other central banks such as the ECB and BOJ have been continuing to pursue ultra-easy policy in while the US Fed has been at minimum removing monetary ease.
But the message from the FDI says that’s not the case, that the appreciation of the US dollar suggested by the forex measures is in fact real. I see this as a consequence of the above mentioned collision between rates merely moving towards normalization with the massive build up of debt due to the prolonged period of ultra low rates preceding it. It will continue as long as these conditions do.
In this respect the metaphor of drug addition is appropriate. Due to the extended administration of the ultralow rate drug, the system has become adapted and begins to display withdrawal symptoms merely from a decrease in the dosage. Rate cuts are really only effective as a temporary measure; if they overstay their welcome they no longer stimulate and the system begins to need low rates just to maintain the status quo. Discontinuing the drug and enduring the withdrawal is the only path back to health … simply increasing the dosage ad infinitum to chase the past high ultimately will kill the addict.
I suspect Jay Powell understands this in his bones and that this explains his determination to normalize rates despite the obvious objections. To perhaps stretch our metaphor beyond its limits, you could think of my proposal to maintain quantitative easing while normalizing rates as a kind of monetary methadone…