In an earlier article for Invezz regarding the Fed’s November 2022 meeting, I referred to the 2% trap,
Perhaps global central banks, in a bid to maintain credibility have committed themselves too firmly to the 2% level.
As per my knowledge, there is nothing hallowed about this number and it certainly would make little sense that it be uniformly applicable across so many countries over decades.
……
The flexibility to admit that inflation will likely have to head north, in the long run, to say 3% may have afforded much-needed breathing space to monetary authorities.
However, today, the inflation-targeting central banks have boxed themselves into a corner, that has the potential to inflict huge costs on economies in search for this 2% number.
Any capitulation on their part could drive stagflationary forces and a loss of credibility.
Might it be that the insistence on returning to 2% is not only unrealistic but narrowing the Fed’s options?
Ongoing inflation?
Despite the crisis that has ripped through the US’s regional banks, the Fed hiked rates by a further 25 bps to 4.75%-5.0%, in a bid to restore price stability to 2% levels.
Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, stated,
…we’re not going to get anywhere near two per cent, maybe not even in our lifetimes.
So, is this a lost battle?
Certainly, inflation has remained worryingly high despite a series of aggressive hikes and quarters of negative growth.
Inflation has been elevated with the CPI, core CPI, PCE and core PCE at 6.4%, 5.6%, 5.4% and 4.6%, respectively.
Nonfarm payrolls, too, came in stronger than expected.
Soft pivot
However, the Fed may have already executed a ‘soft pivot’, replacing the phrase “ongoing increases” in its latest release with “closely monitor incoming information” to chart its next steps.
In stark contrast, only two weeks earlier, Chairman Powell announced plans to potentially hike rates by half a point.
However, the sudden emergence of the banking crisis led to the closure of SVB and Signature, as well as chaos among plenty of other institutions.
The FRA-OIS, a measure of ‘distrust’ and stress in the overnight markets continues to head higher, reaching 42.20 at the time of writing, having been as low as 3.10 on 8th March.
I had written about some of the challenges facing American banks in an earlier piece here, which have already seen a considerable tightening of financial conditions, especially for small businesses and homes that rely on regional banks.
Danielle DiMartino Booth, a former Dallas Fed advisor and CEO of Quill Intelligence noted,
… (it is) premature to declare victory on the banking crisis…We’re nowhere near the end of whatever this saga is…it is not over yet.
In ominous signs of what may be to come, PacWest Bancorp was down 8.6% at the time of writing, while First Republic Bank had fallen 5.7% on Thursday.
Comerica Bank shares are in free fall as well, losing 8.6% through the day so far.
Just before the Fed’s announcement, the 2-year treasury was yielding 4.2%-4.3%, which declined sharply to 3.9% levels at the time of writing, indicating that the broader markets do not share the Fed’s view on having largely resolved the banking situation.
Dot plot divergence
The much-awaited dot plot signals rate cuts in 2024.
However, with projections ranging from 2.4% to 5.6%, the sharp divergence also points to brewing disquiet among the FOMC members and the potential ineffectiveness of future Fed policy.
The not-so-mighty dollar?
Schiff believes that,
The dollar is going to implode.
Although the greenback remains the poster child of fiat currencies, inflation has been stubborn, remaining in the vicinity of four-decade highs.
The dollar suffers from the age-old problem that eventually plagues most reserve currencies, of incredible volumes of national debt and staggering interest payments.
Relative inflation is a key measure of confidence in a currency versus other viable alternatives.
The momentum gained by supporters of the BRICS currency, the widely-shared sentiment that the US is no longer a responsible steward of its reserve currency status given the sheer volume and scope of its sanctions, and the rapidly altering geopolitical arena, all point to a shift in the monetary landscape.
I discussed some of these aspects in this piece.
The petrodollar has been central to maintaining dollar hegemony over the past eight decades.
Countries that are heavily involved in the oil trade for instance are increasingly looking for alternative arrangements.
Today, the attempt to mainstream the petro-yuan and ballooning Russia-China energy trade points to the dollar’s declining significance. For more detail on Russia’s partnership with China, check out this article.
In the future, this could imply that much of the excess dollars that have found their way overseas may fall out of relative favour, forcing the greenback to head to the US, leading to a surge of money in circulation and fuelling further inflation.
Reversing quantitative tightening
Andy Brenner, MD of National Alliance Securities, also in conversation with Schiff, was emphatic in his assessment of the hike,
I think he made a huge mistake… I mean the Fed last week had to put 440 billion (dollars) into the system. The Home Loan Bank put another 300 billion…that’s effectively wiping out the whole QT that they’ve done in the last 11 months and it’s going to get worse, worse and worse… We need to lower rates (by) 100 basis points. Forget about inflation for the moment.
With elevated rates for now, and bank failures set to rise under the burden of higher borrowing costs, deposit outflows and a suddenly tighter overnight market, the authorities will have little choice but to ease policy and inject increasingly large volumes of capital, also driving inflation higher.
This is where the operations of the Federal Deposit Investment Corporation (FDIC) are especially at risk since the body is estimated to only hold funds equivalent to approximately 1% of total American deposits.
Thus, more bank failures could end up pushing inflation even higher since authorities would have to print more money to fill these holes.
Terminal rate and waning credibility
Although the Fed has indicated a decline in rates next year, the terminal rate at the end of 2024 has shifted higher from 4.1% in December to 4.3%, communicating that policymakers intend rates to stay higher for longer.
In a manner, this is also an admission that inflation is more stubborn than earlier thought.
Despite being front and centre in everyone’s mind, Chairman Powell largely side-stepped banking issues, instead referring media persons to Michael Barr, the Vice Chair of the Federal Reserve for Supervision.
The markets did not seem convinced by the Fed’s resolve in the face of bank fragility, with the dollar’s old foe, gold, rising above the $2,000 mark.
Last hike?
In all likelihood, this meeting may well mark the final tightening action of this cycle, although this will continue to depend heavily on how resilient the banking system remains in the weeks ahead.
By the Fed’s calculations, rates will have to stay elevated for longer to combat inflation which shows limited signs of easing.
It is also worth noting that geopolitical tensions are very much at risk of being exacerbated, global supply chains have not fully recovered to their pre-pandemic state, and the world is fast shifting towards a unique multi-polarity where new relationships are being forged.
Each of these factors could prove to be inflationary for the dollar, and with demand-led monetary policy looking spent, returning to a 2% target is looking more unlikely than ever.
Inflation is expected to require higher, sustained rates; bank fragility, multi-polar, protectionism
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Shivam Kaushik
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