High Inflation Will Not Be A Problem, But Dollar May Decline Further

There has been growing concern that much more rapid inflation might be in the future of the US as the Federal Reserve has pumped in countless reserves into the banking system and as the federal government has created more budget deficits for the near term, with more to follow.

Gold prices gold prices rose dramatically beginning in March, reaching a new historic high $2,074.90 on August 6. Many analysts tied this rise to an expectation of higher future inflation.

The consumer prices index showed a monthly gain of 0.6 percent for July, to match a 0.6 percent monthly gain for June. Although both of these numbers were higher than most forecasters had expected, on a year-over-year basis, the rate of increase in the overall consumer price index for July came in at 1.0 percent. Core prices, the index the Federal Reserve targets, rose 1.6 percent year over year, indicating that inflation has roughly returned to where it was before the coronavirus pandemic hit the economy.

Impact On Inflationary Expectations

The impact of the pandemic on inflationary expectations took a similar path. If you look at the inflationary expectations that are built into the 10-year US Treasury yield, you see that inflationary expectations took a hit in February and March, and the economy dropped into a recession but has risen since then.

For the month of January, the inflationary expectations built into the 10-year Treasury averaged around 1.75 percent. In February, these expectations dropped to about 1.65 percent, before falling to around 1.00 percent in March.

In May, expectations rose to around 1.10 percent, followed by increases of 1.15 percent, 1.35 percent, 1.45 percent, and 1.60 percent, respectively, in the April through August period.

In other words, inflationary expectations have rebounded and are near the level they were before the impact of the pandemic hit. The expectations are returning to a level closer to the Fed’s objective range for consumer price inflation, although still below what the Fed would like to see.

Furthermore, market participants do not appear to have a concern that inflation will really accelerate in the near future and become a major problem over the next ten years. One gets the same result when one looks at the inflationary expectations for the next five years.

I agree with the markets’ assessment of the future acceleration of inflation.

What’s Going On?

The question can be asked, therefore, what is going on in gold, in bond, and in the value of the US dollar?

James Mackintosh tries to answer this question in his column in the Wall Street Journal.

For one, Mr. Mackintosh indicates that:

There is a strong link between TIPs and gold, but not so strong as to explain everything.”

In the first case, one can see that this relationship held in the March through August period as the Federal Reserve pumped reserves into the financial system and the government created greater budget deficits that needed to be financed. I have attributed this in previous articles to the flows of international monies. During this time period, money flowed out of the United States into “safe haven” assets, so the money flowed out of US Treasuries, reducing the yield on TIPs, and one of the places the money went was into gold. Thus, the correlation.

But secondly, there was a change in how the world investment community viewed the responses to the pandemic being made by the federal government. Over the past few years, the Federal Reserve and its chairman, Jerome Powell, had gained significant trust in the world relating to how monetary policy was being managed. The initial responses of the Fed to the pandemic crisis had been very well-received within the world.

This “trust” did not extend to the rest of the federal government, and in the February/March response to the growing crisis, a significant change took place in how world investors viewed US leadership.

As Mr. Mackintosh states:

To be clear, I don’t think the dollar is about to lose its status as the world’s anchor currency. But, whatever the (miniscule) probability before the pandemic of the dollar ending its reign, it is clearly much higher now as America withdraws from international engagement and takes on China. That probability justifies diversification…”

In other words, investors around the world have less trust in the political leadership in America than has been the case in the recent past.

Getting out of US Treasury bonds, selling US dollars, and moving into gold has become an important strategy of the world investment community.

The Value Of The Dollar And More

So, as the US dollar rose in value immediately after the US lockdown began, it began to decline in value as we moved through the spring and into the summer. The US Dollar Index (DXY), which was over 100.00 in May, is below 93.00 this morning.

On March 20, 2020, one euro cost $1.0667 at the close of the day. This morning, one euro cost $1.1880.

This decline in the value of the dollar is likely to continue throughout the year.

And the price of gold?

As I wrote in a recent post:

Paul Tudor Jones of Tudor Investment Corp wrote in a letter to in a letter to investors that ‘the price (of gold) could reach $2,400 an ounce.’ He added that ‘If demand becomes as extreme as it did four decades ago, before then Federal Reserve chair Paul Volcker ratcheted up US interest rates to tame inflation, prices could reach $6,700.’”

Note, however, that these are asset prices. They are a part of the financial circuit of the economy, and so, are a beneficiary of the government’s credit inflation. They are not a part of the real economy, and hence, will have little or no impact on the price inflation that the Federal Reserve targets.

Furthermore, what is happening in these markets will benefit the wealthier, more sophisticated investor and will not provide much help at all to the rest of the income spectrum. Hence, expect greater income/wealth inequality.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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