After a very long time, there is a monster in town and it’s rearing its ugly head again. The latest inflation numbers have been no less than daunting, and clearly the big question is hovering over our heads: Is this finally the break with our decades-long deflationary cycle, and will rising prices become a new normal? To be sure, we are a long way from having any certainty, but the Cassandras have been busy touting their prophecies of doom.
The majority of the FOMC members have so far dismissed such prospects. Transitory is the term they use, as spikes in price increases are perfectly legitimate in light of the stimulus packages and the ensuing demand creation, but in the scheme of things, any inflation shocks will be ridden out over time. The problem is that the bigwigs at the Fed have probably overused and are married to the transitory term. Their reputation is staked on the very premise now.
What this leads to is generally very sensitive markets. Only the threat of one of the governing council members to dissent and trigger a debate about adjusting asset purchases, or god forbid, starting to raise rates sends the shivers down investors’ spines. And so, as the April FOMC minutes were released on Buddha’s birthday indicating that some members in fact made suggestions to that extent, risk markets puked and 10-year Treasury yields swung up.
Like sharks, the markets smell blood in the water, and investors are the first to diss the Fed’s and other policymakers’ transitory lingo. To be fair, the inflation phenomenon may well be transitory. That is not necessarily the issue. The issue is that the Fed has a credibility problem because the fate of the money system relies on the monetary status quo. Jay Powell and some of his colleagues have overdone it and pushed the transitory inflation playbook a little too much.
As private institutions and foreign buyers have been getting cold feet, the US Treasury has to rely on the Fed and the commercial banks to lift the burden of accommodating a budget deficit that runs at an annualised 15%+ of GDP. The banks already hold in the vicinity of 4 trillion Treasury bonds by way of the carry trade. Janet Yellen is asking for more of them, but the economic logic would fall apart if short rates were to rise disproportionately to long rates.
The Fed cannot see any joy in being put in the position of ending up holding the bag. It is also beginning to have an effect on current and capital accounts balancing, as I
pointed to recently. The stimulus monster will only push America’s current account deficit further into the red, and surplus countries like China and Japan withdrawing from the previously complementary vendor-financing mechanism will inevitably put unprecedented pressure on the exchange rate.
Accounts must balance, always, and if goods and capital flows can’t take care of it, then the dollar will have to depreciate to fix the disequilibrium. But then again, if the experiment of tapering, higher rates, and a lower dollar couldn’t lure overseas excess dollars back to America, we would start to be flying too close to the sun. It may be as dangerous as never before to bet on the greenback from here, despite the bouts of strength due to this recovery year’s growth forecasts.
Fears about the demise of the US money system as we know it have not abated since the financial crisis, and the ever-higher national debt and evermore bloated Fed balance sheet justify them. To protect oneself, gold as the proxy for the non-inflatable good has performed well recently, better than the if-you-can-hold-your-nose crypto proposition. Also, I would continue with my bullish call on the Renminbi, a currency that is structurally poised to further appreciate from here.
