A Few Thoughts with Year-End Approaching

December 14, 2021

Historic Yearend Weakness of Dollar Against Europe’s Dominant Currency: This yearend tendency was very pronounced during the early days of flexible dollar rates following the March 1973 abandonment of fixed parities. Between mid-December and end-December from 1974 through 1987, the dollar recorded a net gain against the Deutsche mark only in 1984, while depreciating in those end-of-year weeks in each of the other 13 years. The dollar’s average loss over all fourteen of those years during the second half of December was 1.7%.

Seasonal dollar weakness in late December became gradually less pronounced thereafter. Over the ten years through and including 2014, the dollar posted zero net movement against the euro between mid- and end-December and appreciated on average 0.5% in the six Decembers ending in 2015. Two plausible reasons for the fading seasonal dollar bias  in late December include low inflation in the U.S. and elsewhere and the unification of European monetary policies and the region’s currency after 1998. But just as it seemed that any dollar bias toward weakness had all but vanished, the phenomenon may be making a comeback. In the last five Decembers, the dollar fell during the second half of the month against the euro by 1.1% in 2016, 2.1% in 2017, 1.2% in 2018, 0.7% in 2019 and 1.2% in 2020.

What’s really to be Gained by a More Forceful About-Face in Fed Monetary Policy:  The FOMC is widely expected to announce a faster planned tapering of bond purchases on Wednesday. At the November 2-3 policy review, officials agreed “to begin reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities” in November and to cut those sums by like amount further in each ensuing month. At that pace, purchases to add to Fed’s holdings were set to end altogether after June 2022, but replenishment of maturing holdings would continue. Interest rate lift-off would come later, too, but a move by the second half of next year was not ruled out. In the face of higher-than-expected inflation, the Fed would be paying closer attention to the path of prices but not abandoning a patient approach. The thinking then, and presumably now, was that the rise of inflation, while sharper and more enduring than anticipated, was being driven mostly by transitory factors and therefore self-limiting.

A concern I’ve been mulling is that just tweaking policy gradually is unlikely to affect the path of inflation over the next twelve months especially if the broad analysis of the problem’s causes is correct. If the aim is to bring the demand and supply of materials and workers into better balance, policy needs to change forcefully, not gradually. Higher interest rates will not address supply-side bottlenecks and the dependency on foreign sourcing and just-in-time inventory management. Those issues would be better addressed through a strategy of constraining Covid to being no more infectious or serious than the flu.

I’m not arguing that reining in monetary accommodation would not be effective, only that it would need to be done forcefully enough to have a material dampening effect on aggregate demand. If a central bank is willing to do whatever it takes to slow inflation fast, it has the means to do so. The Fed went a whole year from mid-1981 to mid-1982 with America immersed in a deep recession before cutting an ultra-restrictive interest rate. By the way, the same cannot be said about a central bank trying to lift inflation after allowing a deflationary mindset to take hold as happened in Japan. And I’m not saying that central banks should dismiss a rise of inflation that far exceeded what had been anticipated initially. One big difference since early 2021 when those forecasts were made is the sequence of variants like Delta and Omicron, and a related problem of public push-back against  masking and vaccination have also made the pandemic’s course much more unpredictable from both a medical and an economic perspective. That said, one hopes that the FOMC and Fed staff give considerable thought to understanding exactly what they hope to achieve by tweaking policy and to the particular avenues through which their decisions could prove beneficial.

The Role of Inflation Expectations: Few developments worry a central banker more than losing the  public’s trust in their mission to preserve price stability and to restore such after a shock such as experienced since early 2020. A powerful motive to act is to demonstrate that monetary policymakers aren’t sleeping at the switch. Many other central bankers have raised key interest rates this quarter, including those in Romania, Mexico, Ukraine, Armenia, Pakistan, Hungary, Brazil, Russia, Georgia, Iceland, the Czech Republic, Chile, Kazakhstan, Tajistan, Peru, Colombia, Jamaica, New Zealand and Poland. Renowned academic economists like former Treasury Secretary Summers and Nobel Prize winner Krugman have taken different positions over how shortlived the present bout of inflation is likely to be and whether recent Fed policy has been appropriate. The recession of 2020 wasn’t like any other in living memory, so there is a uniqueness to current circumstances that allows for a wide array of future scenarios. The fact that other central banks have gotten very aggressive in the withdrawal of monetary accommodation creates greater risk that those following a patient approach could lose the trust of their public.

Sometimes the fastest economic response to a rise in central bank interest rates is through the an appreciating currency. Fed tightening in the early 1980s helped double the dollar’s value against the German mark from DEM 1.70 to DEM 3.47 by February 1985. A rising dollar that constrains import prices is one way to fortify confidence in a return to in-target price inflation, but such would exact a toll on export competitiveness. One reason for changing policy in a slow and patient way is to not rock the boat.

38,916 or Bust: The Dow Jones Industrials closed today at 35,544, just over a 1000 points below its record high of 36,565 touched not  long ago. Upside traction has been tough in the upper thirty thousands, and that calls to mind the experience of the Japanese Nikkei-225. Japan’s stock market peaked in the final trading session of 1989 at 38,916. That was 32 years ago, and for those believers in long-term equity appreciation as a no-lose bet, know that the Nikkei closed today at 28,433, still some 27% weaker than at the end of 1989. If 32 years isn’t a long-term span  of time, what is? And the backdrop to how the Nikkei fell into a black hole provides a teachable moment. Inflation was rising in Japan and many other countries, and the Bank Japan had a scheduled changing of the governor, which it did every five years. The new leader was determined to get off to a forceful anti-inflationary start. BOJ tightening regrettably proved way excessive and,  worse, didn’t begin to loosen until well into 1991. In the 1990s, Japanese officials at the central bank and in the government engaged in a lot of upbeat rhetoric about faster growth being around the corner, and the economy gradually slipped into a deflationary state of mind from which full escape is still proving elusive.

Copyright 2021, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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