Summary of Key Points:-
- Fed Chair Powell “upping the ante” on monetary policy – but has he gone too far?
- US Employment and Wage Trends
- US government budget deficit and debt ceiling
- Is the US credit crunch coming?
- US rent inflation closer to reversing
Fed Chair Powell “upping the ante” on monetary policy – but has he gone too far?
Currency markets have been forced to negotiate some very difficult and conflicting cross-currents of change and events around the world over recent years. The Covid pandemic which severely disrupted economic activity, the extraordinary fiscal and monetary stimulus policies implemented by central banks as a result of the pandemic, the Russian/Ukrainian war which disrupted trade, food and energy supplies; and now three years of the unprecedented speed of monetary policy tightening to control the inevitable rising inflation from the previous money printing and 0% interest rates.
Always at the center of exchange rate movements is the direction of US monetary policy by the Federal Reserve, changes in US interest rates and thus the value of the US dollar. The USD weakened against all currencies in 2021 as the Fed increased the supply of USD with their money printing. The USD strengthened against all currencies during the first nine months of 2022 as US interest rates were raised in response to significantly higher inflation triggered by significantly higher oil prices from the Russian/Ukrainian war. Since October 2022, the USD began to weaken back from a peak as currency markets concluded that US inflation had already peaked and the Fed would eventually pause and reverse its tight monetary policy stance. There did not appear to be any major risks to the view that the USD would continue to weaken in 2023, as US inflation was falling as fast as it rose in 2022. However, the USD has staged a minor comeback during recent weeks (resulting in the NZD/USD rate falling from 0.6500 to 0.6100) as the Fed and financial markets have reacted to marginally stronger January/February US economic data and expressed fears that inflation will rise up again.
The question facing the markets today is whether the Fed is now going too hard (“too hawkish”) with the latest signals of even further interest rate hikes – earlier, higher and longer?
Are they right in assessing that inflation risks turning upwards again? I do not think.
The Fed admitted a serious policy error when it concluded that rising inflation in 2021 was merely “transient”. They got it horribly wrong then, and the author seems to be on the precipice of going disastrously wrong again by tightening too much. Of course, Fed Chairman Jerome Powell always gives himself “an out” by saying that monetary policy signals and settings will always depend on the economic data that develops. Last week, Chairman Powell “raised” the prospect of further rate hikes with his two testimony before government committees. US bond futures prices moved to a 70% probability that the Fed will raise interest rates by 0.50% at their next FOMC meeting on March 22. However, some doubt has since crept into the markets and pricing has been reduced to a 50% probability ahead of the Non-Farm Payrolls employment figure on Friday 10 March.
Looking ahead, the following developments and events in the US will (in our view) determine the Fed’s interest rate decisions from here and hence the future direction of the US dollar:-
US Employment and Wage Trends – The increase in new jobs (Non-Farm Payrolls) in February was again above previous forecasts of 311,000 (consensus forecast +210,000). But again, the increase in wage rates was below the forecast of +0.20% for the month. The wage increase in February was the lowest monthly increase in the last 12 months. The February results highlight the trend that while strong service sector employment growth on the surface suggests risks to higher wages and higher inflation, the reality is that the job gains are in the significantly lower-paid leisure and hospitality sectors, and thus overall wages. is not pushed up too much at all. The USD weakened (EUR/USD rate back to $1.0700 from below $1.0600) after the employment data as the messages were very mixed. The fixed income market has returned to pricing in a 0.25% increase on the 22nd, no longer a +0.50% increase.
The Fed seems fixated on the fact that labor market imbalances, where demand exceeds supply, automatically send wages and inflation higher, according to conventional economic theory. However, these are not conventional economic times. The increase in jobs being filled each month is just thousands of Americans returning to their workplaces in hotels, restaurants and bars after the money runs out from the Covid handouts. It would be inflationary if wages were pushed up by the increased demand for labor due to the economy growing rapidly. This is clearly not the case, it is purely a lack of manpower. The solution to the imbalance in the labor market is not to crush the economy with higher interest rates (the RBNZ is doing the same). The solution is to increase the supply of labor from foreign immigration, government child care subsidies to get women back into the workforce (as the National Party is proposing in NZ) and lure back the 40 and 50 year old Americans who left normal employment during Covid and are never returned.
US government budget deficit and debt ceiling – The US federal government with large internal budget deficits is never a positive fundamental for the USD value. President Biden wants to reduce the size of the deficits in the coming years by increasing taxes on the wealthy (up to 45% income tax on annual incomes over $1 million). Former President Donald Trump cut tax rates for corporations and the wealthy, spurring stronger economic growth and a stronger USD at the time. Higher taxes are a negative factor in the USD as business entrepreneurs and business investors pull back on their activities and risk taking ie. negative for economic growth.
Over the coming months, financial and investment markets will reflect increasing uncertainty surrounding the federal government, which is running out of cash as it cannot borrow additional funds as it has reached the debt ceiling limit. The situation can never be positive for the USD value as the risk of debt default looms. However, the politicians will always compromise before the bell rings and find a way to “kick the can down the road” by extending the border.
Is the US credit crunch coming? – The negative consequences of the rapid tightening of monetary policy by the Fed over the past 12 months are starting to show in parts of the US economy, which must be very worrying for everyone. The collapse of Silicon Valley Bank on Friday, March 10, may well turn out to be the classic “canary in the coal mine” indicator that the credit crunch is underway. The lightly regulated US regional banks (outside the Big 10 banks) appear to be under financial pressure from squeezed interest margins and loan defaults. Auto loan default rates are rising and consumer credit/mortgage backed securities are under stress. None suggest an increased risk of a US financial/debt/banking crisis; however, the warning signs cannot be ignored. The Fed itself must be very conscious of not being the cause of such a financial crisis.
US rent inflation closer to reversing – Over the past few months, our currency column has highlighted the importance of understanding the measurement and reporting of housing rental trends in the US, as the data is inexplicably delayed, but it is a heavy weighting in the CPI and PCE inflation indices. The chart below (from a Fed report) highlights the extreme time lag between three rental market metrics (CoreLogic, Zillow, and RealPage) and the official rent component of the PCE Housing Services Inflation Index. The PCE housing services index (red line) is set to decline over the coming months and will be a major contributor to continued reductions in the US annual inflation rate.
Our view is that this latest bout of Fed hawkishness and USD strength has run its course. Upcoming US CPI inflation and retail sales data this week (March 15 and 16 respectively) appear to support lower US interest rates and a lower USD value. The Kiwi dollar has already risen from 0.6100 to 0.6180 against the USD and further NZD gains are expected this week.
Both the markets and the Fed have been spooked by marginally stronger US economic data in recent weeks. Both have overreacted to not unusual short-term volatility in the economic data, but we are now seeing an appropriate correction to this overreaction.
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*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has been writing commentary on the NZ dollar since 1981.