The Fed is Dollar-Dependent, not Data-Dependent

The Fed is set to lower interest rates tomorrow, and as you know, I’ve questioned the justification for a cut. But nevertheless, with the market demanding it, we’re likely to soon see the first rate cut since the financial crisis.

Mr. Powell and the Fed continue to claim that their actions are data-dependent, but the question is beginning to arise: What data are they dependent on? The fact that many Fed officials have referred to this as an “insurance cut,” almost by definition suggests that fundamental economic data doesn’t justify a move lower.

Thus, could there be ulterior motives for the cut? Is it possible that the Fed wants to splash some cold water on the strong dollar? Or simply get more in sync with global central banks? And if low inflation is the main driver of the rate cut, do we actually stand any chance of seeing higher inflation?

Let’s begin this discussion by recognizing that the economy is still growing at an above trend rate. The preliminary reading on  2nd quarter GDP, released last Friday, was 2.1%. That figure came in above expectations (1.9%) and also included a substantial drop in inventories. Had inventories remained the same, GDP would’ve expanded at a 3% rate.

Of course, there were still some concerns in the report. While consumer spending was strong, business fixed investment fell 0.8%, marking the biggest drop in three years. This obviously is not great, but do you really think it’s access to cheap capital that’s the problem? If so, I have a lovely bridge to sell you.

No, the drop in business investment is primarily the result of trade disruptions. Corporations are unsure what the global trade environment will look like in the near future, and thus are refraining from making any big commitments. Getting a quarter-point discount on their financing is unlikely to change anything in that regard.

So if a rate cut is not likely to spur business investment, will it at least help with inflation? Maybe, but probably not.

What many people fail to realize is that inflation has been subdued for almost three decades. The era of low inflation began in the early 1990s, as technological innovation brought us the internet and we embarked upon mass automation and outsourcing.

As you can see below, core PCE (the Fed’s preferred measure of inflation), hasn’t been above 2.6% since 1993 – about 26 years ago.

Core Inflation

With the internet providing price transparency on a massive scale (forcing corporations to compete heavily on price), and mass automation and outsourcing continually driving down production costs, it’s really no wonder that inflation has been muted. So while cheaper money probably won’t hurt, there’s a good chance it won’t have a major impact on overall inflation, as inflation tends to be more of a global phenomenon these days.

Another possible reason for lowering rates has to do with strength in the dollar. As you can see below, the dollar remains very strong, and this is harming the competitiveness of U.S. exporters.

U.S. Dollar Index

Last week, it came to light that our administration had discussed a proposal to intervene in foreign-currency markets to weaken the dollar, but ultimately decided against such action (for now). We know that central banks do indeed target the value of their currencies in setting monetary policy, but outright intervention in the currency market would be a bold shift.

In case you’re wondering, the 1934 Gold Reserve Act does give the White House the power to intervene in the currency market, and the Treasury maintains a fund specifically for this type of intervention. The last time the Treasury conducted a currency intervention was in 2000.

Also, it’s worth pointing out that the Treasury does a biannual review on the currency practices of foreign governments, and declined to label any as manipulators in their most recent (May) report. They do list countries whose currency practices are considered “suspect,” and that list includes China, Germany, South Korea and Japan. Recently, Italy, Ireland, Malaysia, Singapore and Vietnam were also added to that list.

So if the Treasury isn’t going to weaken the dollar, then perhaps the Fed feels it’s their responsibility. This could certainly be the case, as according to reports, Trump told advisors he feared ECB president Mario Draghi was starting a currency war, and that Mr. Powell was too naïve to recognize it.

In a way, this notion of other central banks forcing the Fed’s hand is actually true. Greg Ip is the Chief Economic Commentator for the WSJ (brilliant guy), and he recently made the case that if the ECB continues to lower rates, as they have stated, the U.S. has to as well.

The ECB’s policy rate (which is currently at -0.4%) is already almost 3 full percentage points below the Fed’s, and the ECB has hinted it will soon go lower. The problem this creates is when one central bank lowers rates, and another doesn’t, capital tends to leave the first country, driving its currency lower and applying upward pressure on inflation, exports and economic growth. The reverse occurs in the other country, which in this case would be the U.S.

This dynamic was recently acknowledged by Fed Vice Chairman Richard Clarida, who said, “U.S. rates can diverge to some extent from global rates but there’s a limit to how far that process can go, because of integrated capital markets.”

So apparently, if the rest of the world is in easing mode (which they are) then so too must the U.S., at least if we don’t want to see a suppression effect on both inflation and overall economic growth. In sense, the Fed may be shifting from being data-dependent, to dollar-dependent, in an attempt to share as little of our precious growth with the rest of the world as possible.

If that’s the case, then we are effectively going to get monetary stimulus on top of an already solid economy. The net result is likely to be higher stock prices and stronger economic growth in the near term, but this will also lead to a sharper downturn and less ammo to fight the next recession with, when it ultimately does come.

As investors, our job is not to argue with policy, but rather to keep our portfolios allocated to the areas of the market we expect to deliver the highest and safest returns. Right now, it appears that stocks, and particularly U.S. stocks, remain the place to be.



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