Roger J Kerr sees the American Fed decisions driven by employment & wage trends, deficit & debt ceiling issues, credit stress, and US rent trends. Fed hawkishness and USD strength has run its course, he says

Summary of key points: -

• Fed Chairman Powell “ups the ante” on monetary policy – but has he gone too far?
• US employment and wages trends
• US Government budget deficit and debt ceiling
• US credit crisis coming?
• US house rental inflation closer to reversing

Fed Chairman Powell “ups the ante” on monetary policy – but has he gone too far?

Foreign exchange markets have been forced to negotiate some very difficult and conflicting cross-currents of change and events around the globe over recent years. The Covid pandemic severely disrupting economic activity, the extraordinary fiscal and monetary stimulus policies implemented by central banks as a result of the pandemic, the Russian/Ukrainian war disrupting trade, food and energy supplies; and now three years on the unprecedented speed of monetary tightening to control the inevitable rising inflation form the previous money printing and 0% interest rates.

Always at the centre of foreign exchange rate movements is the direction of US monetary policy by the Federal Reserve, changes in US interest rates and therefore the value of the US dollar. The USD weakened against all currencies in 2021 as the Fed increased the supply of USD’s with their money printing. The USD strengthened against all currencies over the first nine months of 2022 as US interest rates were ramped up in response to the sharply higher inflation sparked by significantly higher oil prices from the Russian/Ukrainian war. Since October 2022, the USD started to weaken back from is high point as the currency markets concluded that US inflation had already peaked, and the Fed would eventually pause and pivot on their 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 decreasing as fast as it went up in 2022. However, the USD has staged a minor comeback over recent weeks (resulting in the NZD/USD rate dropping from 0.6500 to 0.6100) as the Fed and the financial markets have reacted to marginally stronger US economic data in January/February and express fears that inflation will surge back upwards again.

The question that is in front of the markets today is whether the Fed are now going too hard (“too hawkish”) with recent signals of even further interest rate increases – earlier, higher and for longer?

Are they correct in assessing that inflation is at risk of reversing back upwards again? I think not.

The Fed admitted to a grave policy error when they concluded that rising inflation in 2021 was merely “transitory”. They got it horribly wrong back then and the appear to the writer to be on the precipice of getting it damagingly wrong again by tightening too much. Off course, Fed Chair Jerome Powell always gives himself “an out” by stating that monetary policy signals and settings will always be dependent upon the evolving economic data. Last week, Chair Powell “upped the ante” for the prospect of additional interest rate hikes with his two testimonies in front of Government committees. The US interest rate market forward pricing moved to a 70% probability that the Fed will hike interest rates by 0.50% at their next FOMC meeting on March 22nd. However, some doubts have since crept into the markets and that pricing reduced to a 50% probability ahead of the Non-Farm Payrolls employment numbers on Friday 10th 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 thus the future direction of the US dollar: -

US employment and wages trends – The increase in new jobs (Non-Farm Payrolls) in the month of February was again above prior forecasts at 311,000 (consensus forecast +210,000). However, yet again, the increase in wage rates was below forecast at +0.20% for the month. The February increase in wages was the lowest monthly increase over the last 12 months period. The February results highlight the trend that whilst, on the surface, strong employment growth in the services sector suggests risks of higher wages and higher inflation, the reality is that the job increases are in the considerably lower paid leisure and hospitality sectors and therefore overall wages are not being pushed up too much at all. The USD weakened (EUR/USD rate back to $1.0700 from below $1.0600) following the employment data as the messages were very mixed. The interest rate market has returned to pricing a 0.25% increase on the 22nd, no longer a +0.50% lift.

The Fed appear fixated with the fact the imbalances in the labour market, where demand exceeds supply, automatically sends wages and inflation higher, as per the conventional economic theory. However, these are not conventional economic times. The increases in jobs being filled every month is only thousands of Americans merely returning to their workplaces in the hotels, restaurants and bars after the cash has run out from the Covid hand-outs. It would be inflationary if wages were being pushed up by the increased demand for labour due to the  economy rapidly expanding. That is clearly not the case, it is purely a labour supply shortage. The solution to the labour market imbalance is not clobbering the economy with higher interest rates (the RBNZ is doing the same). The solution is increasing the supply of labour by foreign immigration, Government subsidies for child-care to get woman back into the workforce (as the National Party propose in NZ) and enticing back the 40 year-old and 50 year-old Americans who exited normal employment during Covid and have never returned.

US Government budget deficit and debt ceiling – The US Federal Government running large internal budget deficits is never a positive fundamental for the USD value. President Biden wants to reduce the size of the deficits over coming years by increasing taxes on the wealthy (up to 45% income tax on annual incomes over US$1 million). Former President Donald Trump slashed tax rates for corporations and the wealthy and that spurred stronger economic growth and a stronger USD value at the time. Higher taxes is a USD negative factor as business entrepreneurs and business investors pull back on their activities and risk taking i.e. negative for economic growth.

Over coming months the financial and investment markets will reflect increasing uncertainties around the Federal Government running out of cash as they cannot borrow further funds as they have hit the debt ceiling limit. The situation can never be a positive for the USD value as the debt default risk looms. However, the politicians will always compromise before the bell tolls and find a way to “kick the can down the road” by extending the limit.

US credit crisis coming? – The negative consequences from the rapid tightening of monetary policy by the Fed over the last 12 months are starting to show up in parts of the US economy that have to be very concerning to all. The collapse of the Silicon Valley Bank on Friday 10th March may well prove to be the classical “canary in the coalmine” indicator that the credit crunch is starting. The lightly regulated US regional banks (outside of the big 10 banks) appear to be under financial pressure from compressed interest margins and loan defaults. Auto loan delinquency rates are spiking upwards and consumer credit/mortgage backed securities are under stress. No-one is suggesting an increased risk of a financial/debt/banking crisis in the US; however the warning signals cannot be ignored. The Fed themselves need to be very conscious of not being the cause of such a financial crisis.

US house rental inflation closer to reversing – Our FX column has highlighted over recent months  the importance of understanding the measurement and reporting of house rental trends in the US, as the data is inexplicably lagged, but it is a large weighting in the CPI and PCE inflation indexes.  The chart below (from a Fed report) highlights the extreme time lag between three rental market measures (CoreLogic, Zillow and RealPage) and the official housing rents component in the PCE housing services inflation index. The PCE housing services index (red line) is set to decline over coming months and will be a major contributor to continuous 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 (15th and 16th March respectively) seem likely to support lower US interest rates and a lower USD value. The Kiwi dollar has already bounced off 0.6100 to 0.6180 against the USD and further NZD gains have to be expected this week.

Both the markets and the Fed have been spooked by marginally stronger US economic data over recent weeks. Both have over-reacted to not unusual short-term volatility in the economic data, however we are now seeing the appropriate correction to that over-reaction.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.