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Three Questions: June 18

CalendarJune 18, 2022

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we'll be watching: 

1. Will Jerome Powell bow to political pressure as he attempts to regain control of the inflationary narrative?  

Under Chairman Paul Volcker, the Federal Reserve tackled high inflation in the early eighties by raising benchmark interest rates to unprecedented levels, deliberately weakening borrowing and economic activity. The policy ultimately succeeded in taming price growth, but Mr. Volcker faced enormous opposition at the time, becoming a reviled figure among business owners and regular citizens alike. Car buyers mailed him their keys, complaining that loans had become too expensive, and home builders mailed him pieces of wood, claiming that they were no longer needed. A two-by-four chunk of lumber that he kept in his office for years had “Please lower these insane interest rates” printed on it.

Interest rates remain far below the 20 percent peak reached four decades ago, but the current chair, Jerome Powell, will face strident opposition from both ends of the political spectrum when he testifies in front of Congress next week.

He will tell lawmakers the Fed’s commitment to stabilizing prices is “unconditional”, implying that the central bank willing to raise rates until the economy slows. Following comments made during Wednesday's press conference, he also might suggest that policymakers are now using a broader set of metrics to measure inflation, recognizing that the headline consumer price index and consumer expectations survey numbers are more reflective of household psychology than the core personal consumption expenditures index that has been targeted traditionally. 

This message might help reduce political tension, helping to convince elected leaders that the Fed is responding to the same pressures they’re facing. 

But the strategy also comes with risks. 

Although the headline consumer index can seem to reflect changes in living costs better than alternative core measures, speculative investment flows often determine price levels, not underlying supply and demand dynamics. Commodity markets can shift direction suddenly, leaving policymakers setting rates under conditions that no longer exist. 

Consumer surveys are notoriously subject to psychological bias and political polarization. Gasoline costs, as the most visible and highest frequency prices in the economy, are overwhelmingly important in driving inflation expectations, despite making up a relatively small proportion of overall household spending. Politically-driven narratives spread on cable news and across social media can dramatically influence the ideas people have about the state of the economy.

In choosing to focus on measures that households and politicians are focused on, monetary policymakers could prompt questions about the central bank’s independence. And by raising rates aggressively even as more accurate indicators of core inflation turn lower, the Fed risks tightening into a downturn, turning a modest recession into something worse. 

Today’s leaders might live to regret turning inflation into a political football - and the Federal Reserve could regret catching it. 


2. Will Banxico boost the peso?

The central bank of Mexico will do its best not to hurt the peso, but that still might not be enough to deliver gains. 

Policymakers are gearing up to emulate the Fed with a rate increase of 75 basis points this week - and to signal more hikes of that magnitude. But, while the move could help stabilize the peso, significant gains in the currency will depend on global risk appetite, and particularly on US fixed income volatility.

Governor Victoria Rodriguez has said the Fed’s increase has been “incorporated” ahead of next week’s decision. Among the hawks, Irena Espinosa already wanted 75 basis points at the May meeting and Jonathan Heath has called for two or three moves of this size. Even dove Gerardo Esquivel has admitted that a big move is on the table. The most recent data showed core prices rising at 7.3 percent, far above the 3 percent goal.

It is very likely that the hike will trigger a hostile reaction from President Andres Manuel Lopez Obrador. The criticism will not have any substantive impact but could serve as a reminder of his quixotic policies and Mexico’s structural backsliding under his administration.

With futures pricing in 75 basis points this week and a terminal rate close to 10 percent in this cycle, the bank is unlikely to disappoint markets. In this environment, the punishment for doing so would be high, even if the rewards of a hawkish stance will depend more on factors outside its control.

Poor Banxico, so close to the Fed; so far from its inflation target.  


3. What will Japan do about a weakening yen?

Probably nothing for now, but don’t underestimate what could be done. 

On Friday, the Bank of Japan said it would continue quantitative easing and yield curve control until it had achieved its 2 percent inflation target in a stable manner. The market’s reaction was to push the yen sharply weaker despite stated concern about “developments in financial and foreign exchange markets and their impact on Japan's economic activity and prices.”

The admission that a depreciating currency might be a problem brings the Bank into closer alignment with Finance Minister Shunichi Suzuki, who was vocal about his unhappiness even two months ago, when the yen was more than 5 percent stronger. Suzuki is not the only one—business and consumer surveys suggest that the import price inflation is hitting real incomes and confidence. 

Nevertheless, the finance minister has made it clear that he respects the Bank’s independence. Japan is that rare case of a fiscal authority complaining that monetary policy is too loose rather than too tight.   

The government’s options are limited while monetary policy keeps Japanese yields substantially below those in the US. 

However, they are not non-existent. 

It is often assumed that interventions to defend a currency against depreciation are doomed because of a reserve adequacy constraint.

But it is not clear that this applies to Japan. The country holds more than 1.2 trillion in forex reserves and domestic financial institutions hold another 3.5 trillion dollars in overseas portfolio assets that are predominantly used to fund yen-denominated liabilities. The resulting asset-liability mismatches have caught these institutions off-guard on several occasions when the exchange rate has strengthened unexpectedly - and if the Ministry of Finance signals a desire to intervene, they could again find themselves forced into the market, buying yen to hedge themselves.

This is not to say that it will happen, particularly if the central bank does not move its yield control target higher. But it would be a mistake to think the world’s largest creditor country has no arrows left in its quiver.




AUD    Reserve Bank of Australia, June Meeting Minutes


CAD    Retail Sales, April

JPY    Bank of Japan, April Meeting Minutes


GBP Consumer Price Indices, May

CAD    Consumer Price Indices, May

USD    Federal Reserve Testimony, Jerome Powell

USD    Federal Reserve Speech, Evans


EUR European Central Bank Economic Bulletin

EUR    S&P Eurozone Purchasing Manager Indices

USD    Current Account Balance, Q1

USD    Weekly Jobless Claims

USD    S&P Global US Puchasing Manager Indices

USD    Federal Reserve Testimony, Jerome Powell

USD    Department of Energy Weekly Inventories

MXN    Bank of Mexico Rate Decision

CNY    Current Account Balance, Q1


JPY Bank of Japan Speech, Amamiya

AUD    Reserve Bank of Australia Panel, Lowe

CAD    Survey of Employment, Payrolls and Hours, April

USD    Baker Hughes Weekly Rig Count


Some of this week’s most interesting, insightful and off beat reads on the state of the global economy:

“Global integration kept prices down and the dollar supported, funding twin imbalances by supplying ample buyers for US paper, which of course only went up in that regime just like all assets. This was turbocharged by a unique global peace under a unipolar dollar standard. The point is that it was a virtuous cycle, and it was a fluke.”

FT Alphaville: An Age of Real Wealth Destruction

“Warnings come almost daily that oil and liquefied natural gas supplies will remain short and prices will rise. Investors shouldn’t forget the other side of the coin: Aggressive monetary tightening is an emerging threat to demand.”

Wall Street Journal: Central Bankers Could Derail the Rally in Oil and Gas

“So, have all the low-hanging fruit gone? Are "ideas" getting harder to find? A team of economists from Stanford and MIT posed this exact question in a 2020 paper. They found that research and development efforts have significantly increased, while per-researcher productivity has declined. In other words, we’re getting less for our time and money. A lot less. They estimate that each doubling of technological advancement requires four-times as much research effort as the previous doubling.”

BBC: Do We Need a Better Understanding of ‘Progress'?

“The crux of the financial tension at the heart of the Eurozone is not in fact one-size-fits all monetary policy, it is the absence of a risk-free asset.”

Philosophy of Money: Euro Crisis II

“The increase in synaptic connections is analogous to new companies, each entering the industry with a novel approach or technology to address the business challenge. The marketplace is the environment, which “selects” the products or services that best fit

the industry’s needs. The decrease in connections is analogous to the exit of companies.”

Morgan Stanley: How Capitalism Experiments

“Target, Walmart and Macy’s announced recently that they are starting to receive large shipments of outdoor furniture, loungewear and electronics everyone wanted, but couldn’t find, during the pandemic. The problem for retailers—that these goods are delayed by almost two years—could be a windfall for those in the market for sweatpants or couches. Look for prices to start dropping around July 4, analysts say.”

Wall Street Journal: Stores Have Too Much Stuff. Here’s Where They’re Slashing Prices.

“Currently P&I is up about 46% year-over-year for a fixed amount (this doesn’t take into account the change in house prices). This is about the same percentage increase as in 1979.”

Calculated Risk: Comparing the Current Housing Market to the 1978 to 1982 period

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