Jay Powell’s announcement last week that the Fed will shake up its inflation-targeting regime did not come as a shock to the markets.  However, the move did increase inflation expectations and pushed the dollar lower.  Looking ahead, is it realistic to expect the Fed to be successful in generating inflation when they (and virtually all other major central banks) have been failing to do this for years?

Inflation that is persistently too low can pose serious risks to the economy.

– Jerome (Jay) Powell, Chair, US Federal Reserve, August 27th 2020, (Jackson Hole Symposium)

Our (new) approach could be viewed as a flexible form of average inflation targeting.

– Jerome (Jay) Powell, August 27th 2020, (Jackson Hole Symposium)

Since inflation makes your currency worth less over time, we need to start asking: Isn’t currency founded on trust in the value of that currency? And doesn’t that mean that by setting inflation target rates, governments have a stated goal of eroding that trust?

– Jeff Booth, ‘The Price of Tomorrow’, 2020

(We) believe that the addition of gold will give the portfolio a strong diversifier to its growth-oriented investments as well as provide an effective hedge against inflation.

– Ohio Police and Fire Pension Fund, Notes from Investment Committee Meeting, August 25/26th  2020

Jay Powell’s comments at the Jackson Hole Economic Policy Symposium last week were not particularly stirring.   When comparing key moments in central banking history, his speech (simply entitled ‘New Economic Challenges and the Fed’s Monetary Policy Review’) did not really have the same oratorical resonance we may recall from Mario Draghi (‘whatever it takes’) or Alan Greenspan (‘ irrational exuberance’).  Boring does not mean trivial, however, and there is little doubt that the adjustments to the Fed’s monetary framework are worth a closer examination. 

Let’s start by looking at the changes themselves.  On the surface, the move from a simple inflation target of 2% to an average inflation target of 2% may not seem like a big deal.  Sure, it means the Fed is prepared to let inflation run a little hotter, and stay a little higher for a while, to make up for the fact that CPI has been below target (see chart I).  But, the reality is that inflation has been running pretty close to 2% in the US, averaging about 1.9% over the past three years (and 1.7% over the last decade).  So depending on how you read it, the Fed is giving itself the ability to allow inflation to creep slightly above 2% for a limited period of time – not exactly Weimar!

Chart I: US CPI (2010 – 2020)

Source: Bloomberg

Sure, financial markets have been rapidly increasing their expectations for inflation since March (see chart II), with inflation swaps predicting the average inflation rate in the US to exceed 2%, from 2025 – 2030 (note: 5yr / 5yr inflation swaps predict the expected inflation rate over five years, starting in five years time).  While this is up a lot from where we were in March, when the market was pricing future inflation to be well below 2%, things still don’t look too alarming.

Chart II: US 5yr / 5yr Inflation swap (orange) vs. Europe 5yr / 5yr inflation swap (blue)

Source: Bloomberg

In the currency markets, however, the verdict was clear – keep selling the dollar as inflationary risks are rising.  EURUSD continued its relentless march towards 1.20, GBPUSD breached the 1.34 level to set a new two-year closing high, and USDCAD is flirting with 1.30 again, a level it has not seriously tested since 2018.  In other words, Jackson Hole has further reinforced the ‘Dollar Downfall’ narrative.

This is understandable.  While the market does not seem to think the Fed’s policy adjustment will lead to runaway inflation, the fact that the Fed has stated it will tolerate more inflation in the future is bearish for the dollar, as Jeff Booth’s comments above imply.

However, I have two concerns with the conclusion that the Fed’s policy change will lead to a weaker dollar in the near term.  First of all, wanting higher inflation and getting higher inflation are two very different things.   While money supply has increased rapidly (see chart III), monetary velocity has collapsed.  In other words, while the Fed is increasing the stock of money, this new money is failing to circulate around the economy.  People are not spending it.   Monetary velocity is measured by a ratio of how many times a unit of money is used in a given period.  From 1959 to 2007, the average rate was about 2 (a dollar got ‘spent’ twice in a year).  Now, this ratio has fallen to just over 1, meaning the Fed’s ‘money printing’ cannot generate the inflation it desperately wants to see.  (Note: There are a number of factors that influence monetary velocity, with demographics being perhaps the most powerful force.  The halving of monetary velocity since 2007 has been accompanied by an increase in the US median age from 37 to just under 40).

In fact, moving to an ‘average’ inflation target is arguably no different than an asymmetric inflation target (where the Fed is as concerned with undershooting the target as overshooting it), something which the Fed already introduced all the way back in 2018.

Chart III: US M2 Money Supply (blue, LHS, USD billions) vs. M2 Velocity (orange, RHS, ratio)

Source: Bloomberg

And even if we give Mr Powell the benefit of the doubt, and assume that he can successfully push inflation higher (and enable what is effectively financial repression), it is difficult to imagine that he will be alone in his efforts.  Other central banks will almost certainly jump on the bandwagon, as they want inflation just as badly as the Fed, and they will also want to ensure their respective currencies do not strengthen too much.  As shown in Chart II above, European inflation expectations have picked up to about the same degree as US inflation expectations, so it is difficult to explain dollar weakness purely as a function of divergent inflation expectations.

As I wrote back in May:

The dollar’s stability is, and will continue to be, closely linked to the credibility of the Fed, and its unique role as the global reserve currency.  If, as we expect, we experience a future phase transition into an inflationary environment, this will reduce the comparative advantage that the dollar currently holds over its peers, increasing the risk of US dollar depreciation in the longer term.

Over the long term, the decision made by the Ohio Police and Fire Pension Fund last week to allocate 5% of its portfolio into gold may well appear prescient, and I expect there will be more of these announcements to come.  Our view remains that we will eventually transition into an inflationary period and that this transition will lead to a (material) weakening of the US dollar.   However, we remain hesitant to believe that this will happen in the near term, Powell’s Jackson Hole comments notwithstanding. The Dollar Downfall narrative could well continue to drive the dollar lower for a while, but we continue to feel that the dollar looks oversold at these levels.

Author: Kevin Lester