We may well at present be seeing the first stirrings of an increase in the inflation rate — something that we would like to happen.


Stanley Fischer

Fed Vice-Chair in a speech before the National Association for Business Economics

Anyone renting an apartment over the last few years might well wonder what rock Mr. Fischer has been residing beneath – and whether it was rent controlled. Certainly not all prices have been as reluctant to rise as the CPI itself which has been running quite a bit beneath the Fed’s target the last few years. But relative price changes, where the price of one good or service rises as another falls are not inflation by any definition. And so despite the rapid increase in rents the even more dramatic drop in the price of oil and other commodities means that the CPI and the other measures of official inflation have not risen as fast as our monetary minders would like. They would like us to be impoverished at a more rapid clip apparently. I’ve never really understood the economic profession’s fear of deflation. It is, after all, the very evidence that capitalism is all it’s cracked up to be. Improving productivity, the very definition of economic growth, is deflationary.

In any case, when I speak of inflation I don’t really care much about the CPI or the other government sponsored price measures. Price indexes are nothing more than attempts – inevitably flawed – at measuring the value of the currency, the US dollar in the case of America. What the CPI or the GDP deflator or the PCE deflator attempt to measure is the purchasing power of the dollar. I prefer to observe the value of the dollar more directly. The various dollar indexes provide us with information about the dollar’s value versus other currencies. Gold provides an indication of the value of the dollar as do general commodity indexes. So when I ask if inflation is about to make a comeback, what I’m really wondering is if the value of the dollar is about to fall. I prefer these measures not because they are more accurate – although I think they generally are – but because they are more timely. Prices will follow the value of the dollar eventually but the impact on investments is much quicker.

The movements of the dollar can have a dramatic impact. Just witness the incredible changes in the energy industry over the last two years as oil prices collapsed. The explanations for that collapse are myriad and some of them conspiratorial but there seems little doubt the dollar played a major role. It is not mere coincidence that the dollar started to rise strongly and oil started to fall at the same time in mid-2014. I suppose one might argue about causation – the fall in oil prices may have caused the rise in the dollar – but that the two were linked seems beyond question. It might be that causation ran both ways but frankly I’m not sure it matters; the dollar value will impact the price of oil and other commodities. There may be other supply/demand fundamentals having an impact on individual commodities but when they rise or fall together, the culprit is always the dollar. And in this case it wasn’t just oil that was falling.

The rise of the dollar and the fall in commodity prices over the last two years has had a dramatic impact on the global economy and markets. South America is in the midst of one of its periodic bouts of stagflation as capital flees and currencies collapse (Chile as usual an exception). Japan’s devaluation – the flip side of the dollar rise – produced rapidly rising Yen profits for Japanese corporations and a bull market in stocks even if the economic results left a lot to be desired. That’s probably because the rest of Asia felt obliged to let their currencies fall against the dollar as well. The fall off in emerging market growth, a function of capital outflows and lower commodity prices, offset any advantage Europe gained by going first in the global currency war, the Euro falling from 150 to 125 before the Yen even peaked in early 2012.

The stronger dollar also had an impact right here at home as lower oil prices pressured the energy industry. The collapse in oil prices and the deterioration in shale companies’ balance sheets pushed credit spreads wider as investors fled the junk bond market. That has had an impact on all lower rated companies trying to get financing in that market and has likely had an impact on growth at the margin. GDP growth has been weaker than expected, the long awaited acceleration deferred again. Capital spending has remained subdued, consumption has grown only slowly as inventories built and individuals opted for more saving. Manufacturing is in recession and profits are down for three straight quarters. In short, the US economy has been a big disappointment.

It is in that now reduced growth outlook that one must look for clues about the future course of the dollar. A brighter growth outlook played a role in attracting capital to the US and driving up the value of the dollar. As that growth outlook has dimmed so has demand for dollars and US investments. The dollar index peaked a year ago and even emerging market currencies have recently been rising against the greenback. The outlook for Fed policy has moved in a dovish direction as rate hikes keep getting pushed out. Global growth expectations are equalizing, something I started anticipating a year ago, and as they do the relative strength of the dollar wanes.

It is frankly hard to see a reason for the US dollar to weaken significantly. US growth may be disappointing but it is still positive and better than most of the rest of the world. Interest rates here are at least positive, something increasingly rare in our upside down world. And while the Fed may be pushing out rate hikes they still seem intent on moving in that direction. So, why would the dollar weaken here? Why would someone prefer Yen or Euros or $A or $C right now, much less Brazilian Reals or Colombian Pesos?

It may be as simple as relative values – asset prices outside the US, especially in emerging markets, are cheap. Maybe China’s economy isn’t in as much trouble as everyone seems to believe. Or maybe they will go on another fiscal borrowing and spending binge. Maybe Europe is ready for a cyclical upturn even if negative rates and QE haven’t accomplished much. The arrest of Lula may mean the Brazilian Petrobras scandal is nearing an end. Is the political change in Argentina a harbinger of better political outcomes in other parts of South America?

A fundamental explanation for renewed dollar weakness may come from closer to home. The US economy is not performing well and bond markets are pointing to continued weakness. Real interest rates have recently slipped into negative territory. Credit spreads have improved over the last few weeks but the trend is still negative. Earnings just logged their third straight negative quarter and Q1 2016 looks to make it four. While a recession probably shouldn’t be the base case for the US, it certainly can’t be ruled out. We probably shouldn’t discount politics either in this election year. The leading candidates – for now anyway – don’t inspire much confidence and most of them seem intent on offending as many foreigners as possible. Not exactly the way to encourage capital inflows that might bolster the dollar.

The markets are already moving toward a more inflationary future. The dollar index peaked a year ago and has been trading in a roughly 8% range since. Gold is up 20% since early December and gold stocks are up quite a lot more. TIPs have suddenly found a bid after trailing the rest of the bond market, up over 3% since mid-December. Copper is up 15%. Crude oil is up a stunning 46% from its low. The SPDR Metals & Mining ETF is up 65% since mid-January. The Materials ETF is up 16%. Even the general commodity ETF, GSG, is up over 17% from its low. The move into weak dollar investments has been rapid and probably reflects more short covering than real investment buying but buying it is.

Inflation expectations, fears, are rising and markets are responding. Markets are not infallible and it could be that these moves are quickly reversed as the deflationary fears of the last few years return. But I have my doubts. It has always seemed inevitable that the aggressive monetary policies of the world’s central banks would end in inflation. We may have finally reached the point where everyone looks askance at fiat currencies, preferring to hold their capital in real assets rather than ones that depend on confidence in economists and politicians. Considering the track record of economists and their models and the current crop of Presidential candidates the only wonder is that it has taken so long.

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