Pain. The path to lower inflation in the US goes through economic pain.
And Larry Summers thinks the public should be apprised of that. “My hope is that we will get clarity that policy is not yet restrictive, that it needs to be restrictive if we’re going to contain inflation and that we’ll need to accept the consequences of that,” he told Bloomberg, while musing about what Jerome Powell might (or might not) say at Jackson Hole this week. That message, Summers said, should “be delivered starkly and clearly.”
It’s not entirely obvious why Powell should adopt a deliberately “stark” cadence. Sure, you want to tell the truth and if the public “can’t handle the truth,” well, then, that’s on them. But I’m not sure you actually gain much in the arena of public trust from deliberately terrifying regular people with tales of job losses of prophecies of precarity.
You might, however, succeed in tightening financial conditions. And that would help alleviate what Summers (correctly) suggested has been a painful experience for officials over the past two months.
He alluded to the FCI easing observed since the July policy meeting. I talked at length about that as it relates to Jackson Hole over the weekend. “It’s got to worry them,” Summers said. “In the middle of a tightening cycle, financial conditions are substantially loosening.”
Goldman echoed the sentiment in several recent notes. I’ll recycle the figure (below) to make the point.
The chart covers the period from the July FOMC decision (and, more to the point, Powell’s press conference, which tossed gas on the risk rally) and the day following the cooler-than-expected July CPI report.
The dollar’s strong showing last week helped apply the brakes, and it’s possible that by the time Powell addresses the audience in Wyoming on Friday, much of the FCI easing impulse will have evaporated into the sweltering summer haze. But that hinges on equities.
“When the July US CPI report posted a softer-than-expected reading on August 10, the market took that as a signal that US inflation may have peaked and that it may have over-estimated the number of Fed hikes” necessary to control inflation, Rabobank said Monday. “This refreshed enthusiasm for US stocks and simultaneously knocked the USD lower, but last week, sentiment reversed,” the bank added, noting the equities’ renewed struggles came as the dollar index rose more than 2% (figure below).
That was partially attributable to more hawkish banter from Fed officials, but a good deal of it came courtesy of other countries’ woes, from the UK’s worsening cost of living crisis to China’s belabored efforts to get out of its own way.
“The dollar continues to perform very well, buoyed by a hawkish Fed and also by the travails of major trading partners which are suffering more from high energy prices and weaker export markets,” ING remarked. “These challenges to ex-US growth models continue to leave the dollar in the ascendance.”
The policy divergence between the PBoC and the Fed is likely to widen further going forward. As expected, Chinese banks lowered both loan prime rate tenors on Monday. The five-year LPR was cut by 15bps. It was the second 15bps cut to the five-year LPR in four months (figure below).
May’s cut, you’re reminded, was the largest since the PBoC revamped the rates regime in August of 2019.
The one-year LPR was lowered by a token 5bps. As a quick refresher, the LPRs represent the best rates offered to customers by a handful of Chinese banks. But, the one-year medium-term lending rate, which China cut last week just minutes before unveiling very poor activity data for July, is a guide. Typically, LPR reductions are presaged by MLF cuts, so Monday’s lowered LPRs weren’t a surprise.
What was notable, though, was the disparity between them. Chinese banks have now reduced the five-year LPR, a reference for home mortgages, by 30bps in four months, six times today’s one-year LPR tweak. Note also that the PBoC lowered the floor on mortgage rates in May to 20bps below the five-year LPR rate. So, all together, that’s a de facto 50bps reduction in home lending costs for at least some borrowers.
That’s indicative of China’s high-wire act — they need to support healthy activity in the beleaguered property market while avoiding any policy actions conducive to speculation. There’s no shortage of liquidity. Additional cuts to the one-year LPR likely won’t accomplish much.
In any case, the reductions underscored China’s growth concerns, and when considered with the economic trials and tribulations of the UK and Europe, the US finds itself in a familiar position as “cleanest dirty shirt.” Although things are going ok in other advanced economies, I’d note that Canada, Australia, New Zealand and Sweden are all hiking rates into property bubbles. Japan is a wild card — inflation is now above-target, and while the BoJ isn’t likely to abandon ultra-accommodative policy during the remainder of Kuroda’s term, even a nod in that direction could catalyze a pretty acute yen rally.
Against this backdrop, it’s possible the dollar could do some of the work for the Fed when it comes to ensuring the FCI easing impulse from higher stock prices doesn’t undermine the inflation fight. The Bloomberg Dollar index is coming off its best week since April of 2020, the pound has its worst week in two years and the euro is back to parity.
This raises the stakes for Powell in Jackson Hole. Hedge funds lifted their net dollar shorts against eight other currencies to the most in a year during the week ended last Tuesday. That suggests some folks are betting on a dovish pivot. As Bloomberg’s Masaki Kondo noted on Monday, the correlation between the Bloomberg Dollar Index and the VIX “has been strengthening in the past six months, underscoring the currency’s allure as a haven.” If Powell fails to deliver the kind of “stark” hawkish message Summers wants to hear on Friday, the dollar could fall with the VIX, short-end US yields could retreat and stocks could run higher, a decidedly suboptimal outcome.
