Foreign Exchange Market Turning On Powell And Federal Reserve

Are we seeing a shift in market expectations relating to Federal Reserve chairman Jerome Powell and the Federal Reserve?

On Tuesday Mr. Powell testified before the U.S. Congress in his effort to get re-nominated at the Fed chair for another term.

During the day of June 10, the Monday before the testimony, the U.S. Dollar Index (UDX) was over 96.00 for the day, hitting, at one time hitting 96.20.

During the testimony, Mr. Powell reiterated the recent Federal Reserve story that inflation had become an issue for the Fed, although it still might be just of temporary nature due to the impacts of the coronavirus pandemic.

He continued that the Fed was now tapering monthly purchases of securities from its recent $120.0 monthly goal, and this would bring the recent policy effort to its conclusion by March.

Following that, Mr. Powell added that the Fed would probably begin to raise its policy rate of interest, and would, in all likelihood raise this rate two more times in 2022.

Mr. Powell stated that the Fed was concerned about how inflation had risen and would certainly do something about it.

And, that was basically his testimony.

Value Of U.S. Dollar Falls

The value of the U.S. dollar dropped during the rest of the day and closed just above 96.00.

On Wednesday, new information on the rate of inflation became public.

The rate at which consumer prices had increased over the past year rose to 7.00 percent.

This was the fastest that consumer prices had risen since 1982!

By the end of the day, the U.S. Dollar Index had dropped to 94.95.

Near the opening of the market on Thursday, the index had dropped to around 94.70.

But, by Thursday morning, the news was out in the New York Times.

The headline read: “Lael Brainard will call inflation ‘too high’ at her Fed nomination hearing.”

Ms. Brainard is facing a congressional hearing today concerning her nomination as the new vice-chair of the Federal Reserve.

Obviously, the Fed believes that it is time to raise the focus on inflation and assure the congress and the financial markets that the Fed truly intends to combat the specter of high and rising levels of inflation.

So, right now, Ms. Brainard and the Federal Reserve are moving the argument to the level that the Fed will do something about the inflation problem that is looming over the economy.

Problem

There is a problem with this.

Mr. Powell, Ms. Brainard, and the Fed do not seem to have a real plan for attacking inflation.

The most that comes out from this presentation is that there will be three increases in the Fed’s policy rate of interest this year.

Well, the president of one of the Federal Reserve’s banks admits that there will be four increases this year.

This would bring the effective Federal Funds rate up to around 0.90 percent if there are three increases and 1.q5 percent if there are four increases.

But, little or nothing is being said about what the Fed might do in terms of reducing the amount of reserves that exist within the banking system.

At the close of the banking week ending January 5th, the commercial banking system held excess reserves in excess of $4.0 trillion.

The Fed has allowed the amount of reverse repurchase agreements to rise to about $1.8 trillion, and this reduces the amount of excess reserves that are in the banking system.

But, if the whole issue to fight inflation is to reduce the reserves that are in the banking system, the Federal Reserve has a real problem.

If the Fed allows the number of reverse repurchase agreements to decline, this means that the amount of excess reserves in the banking system will have to rise unless the Fed begins to sell securities from its portfolio and get them off its balance sheet.

The Fed faces a real dilemma.

Does it allow reverse repurchase agreements to remain as high as they are and just sell securities, or, in an effort to get its balance sheet more in balance, does the Fed sell securities out of its portfolio while allowing reverse repurchase agreements to decline at the same time.

We have heard very little about how the Fed is going to fight inflation by reducing the massive amount of liquidity it has pumped into the economy over the past two years.

Foreign Exchange Traders Are Aware

The traders in the foreign exchange market must be aware of this dilemma facing the Fed and see the dilemma it is faced with.

The issue is that if the Fed does not effectively reduce reserve balances in commercial banks, then inflation will continue and since the U.S. inflation appears to be worse than that facing other major areas of the world, the value of the U.S. dollar needs to decline against other major currencies.

If the Fed does decline to begin to withdraw reserves from the banking system, a whole other picture emerges.

That picture includes a declining stock market, a possible second recession, and further political unrest in the United States.

The Federal Reserve, under the guidance of Mr. Powell, has attempted in every way to avoid creating a drop in the stock market and an economic disturbance.

The Powell Fed has always tried to err on the side of not making a mistake that would hurt the economy. That is why we are in the position we are in today.

In my view, traders in the foreign exchange market recognize this fact and this is why the value of the U.S. dollar seems to be on the decline. This is a different picture than had been drawn in the fall of 2021.