Demand for USD continues to pick up steam as the US Dollar Index (DXY) jumped above the 106 level today, reaching highs not seen since 2002. Today’s USD buying pressure coincides with increasing demand for Treasuries and decreasing demand for stocks; the 10-Year Treasury yield has hit 2.81% intraday, while the Dow Jones Industrial Average has dropped 700 points intraday. Many traders may be wondering how long this bullish run will last for USD, and whether it is still worth hopping on the bandwagon. Will the Federal Reserve continue its recent, historic decent into hawkishness, or will rate hikes and US price increases subside? This leads us to a key question that ought to be explored: just how bad is US inflation?
Insufficient Inflation Proxy
Whenever discourse about inflation involves specific inflation rates, such as the 1% month-over-month US inflation recorded in May, we are not actually referencing inflation itself, per se. This is because real inflation is quite nebulous; markets are extremely complex and organic by design, rendering a perfect gauging of price increases within a whole country practically impossible. This explains why there are so many existing measurements of inflation, such as the Consumer Price Index (CPI), Personal Consumption Expenditures (PCE) Price Index, Producer Price Index (PPI), and more: because no one such measurement is completely reliable.
This is helpful to consider when addressing the shortcomings of CPI, widely considered to be a proxy for inflation. CPI in the US, recorded by the Bureau of Labor Statistics (BLS), is why we say that annual inflation recently hit 8.6%, and hovers at 40-year highs. However, many are unaware that the way the BLS calculates CPI changed in 1983. According to the Economist, writing about research conducted by Marijn Bolhuis, Judd Cramer, and Larry Summers, CPI changes made in light of housing market volatility have ‘distorted’ historical US inflation data. Apparently, adjusting for these changes in calculation, the stagflation of the early 1980s is significantly closer to today’s inflation highs than historical charts reflect (read more here). Unfortunately, this means that today’s hyperinflation is likely even more significant than is recognized.
Daunting Historical Data
Considering how contemporary hyperinflation in the US is closer to historical highs than current CPI data indicates, this presents the Federal Reserve with an even tougher challenge than previously thought. While the Fed has recently shown that they are willing to resort to unusually big rate hikes in eager attempts to slow down hyperinflation, the current federal funds rate has still not even reached 2% yet. By contrast, the stagflation encountered in the late 1970s and early 1980s warranted a far more severe response from the Federal Reserve, with a target interest rate frequently hovering in the double digits, even hitting 20% in 1980.
While today’s Federal Reserve is likewise pursuing tighter monetary policy, these two variations of hawkishness are apples and oranges. A 2% interest rate is a far cry from 20% no matter how you justify it, and considering that rate hikes are still the Fed’s primary tool for stopping a hyperinflation problem that more and more closely resembles that of decades past, the cooling effort may have only just begun. While today’s inflation debacle is certainly not identical to that of 40 years ago (with such variables as significantly higher levels of consumer, business, and government debt possibly increasing rate hike effectiveness), they are far from being dissimilar.
Impact of Globalization
Another significant factor contributing to persisting hyperinflation in the US is globalization. This is because of the frequency with which the US economy indulges in gigantic trade deficits, relying on international supply for the sake of ostensibly cheaper goods, services, and labor. These supposed benefits can exacerbate higher prices in the US when hyperinflation is a global problem, as it is today. The Federal Reserve may be able to create lower demand within the US, indirectly generating lower prices and slower price increases, but their influence over rising import costs is lesser.
For example, while the surging value of USD against other currencies has thus far protected US consumers from the full brunt of import price increases, global supply chain issues have nonetheless left the US vulnerable to sharp rises in food and energy prices. These are particularly difficult dimensions of inflation for the Federal Reserve to contend with, since Chair Jerome Powell cannot hope to finagle monetary policy to increase gas and grain supply or soften Putin’s heart. These worldwide supply problems will likely mean more Fed hawkishness, not less, as these near-ubiquitous conditions dull the effect of rate hikes in the US.
The Fate of USD
The USD bullish run likely won’t last forever. Even in 1985, just after the DXY peaked above the 160 level, price action began to plummet, all the way down to the 85 support zone by 1987. However, considering that the global economy is still deep in the throes of supply crises, wartime concerns with corresponding sanctions, and the aftereffects of unprecedented emergency expansionary monetary policy, the hyperinflation problem is likely far from resolved. Considering that USD continued to soar with inflation in the late 70s/early 80s, in spite of increasing unemployment and periodic contractions in GDP, there seems to be a high probability that USD and US inflation will continue their climb into the near future.
The US Dollar continues to gain strength, reaching DXY highs not seen for 20 years.
Current inflation metrics for the US, such as CPI and Core PCE Price Index, may paint an inaccurate picture of US inflation, as real inflation appears to be significantly worse.
Though US economic conditions are not identical to those 40 years ago, the last time inflation of this magnitude existed, the Federal Reserve needed to resort to double-digit interest rates to cool the economy, a far cry from the current target rate of 1.75%.
The effects of globalization on the US economy mean that prices in the US are also subject to global inflation and supply chain problems, which could likely necessitate additional hawkishness from the Federal Reserve.
Considering the severity of hyperinflation, both in the US and around the world, there seems to be a good chance that USD’s bullish momentum will continue in conjunction.
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