Powell'stestimony,correctinflationmetricandEeswarPrasad

Discussing the centrality of the US economy and US Dollar has been a constant feature of our notes. Time and again it has been proved that the domestic factors play a side fiddle to what’s happening on the global stage especially in the US. Take for example the last week FOMC where a slightly hawkish tone was met with a lot of volatility across emerging market currencies, ZAR dipped by close to 4.5%, Indian Rupee by 1.5%. Similar effects played out across Indonesian Rupiah (IDR), Thai Baht (THB) and many others. What this tells us that the entire world is now meshed together and concepts like “decoupling” is a passe. Readers would remember heavy usage of this world during the GFC when the Indian economy remained resilient even when the world output dropped. However, we realised years later that indiscriminate lending was the hidden medicine which resulted in that growth spurt.

Having argued the Dollar primacy, one can’t hold back from discussing any commentary coming from the Fed’s stable. Yesterday there was Fed Chief Powell’s testimony in front of the Congressional committee on the topic of Lessons learned: The Federal Reserve’s response to the Coronavirus Pandemic. The Fed Chief presented a statement followed by the QnA. The statement was on the expected lines where the inflation was termed as transitory and an economic rebound was termed as robust, but it was during the QnA session where the things really got lively. The questions ranged from the definition of employment, to the correct measurement of inflation to the centrality of USD system. The cautious responses presented a very nuanced approach giving more clarity on the Fed’s thinking. Markets obviously latched on to every word.

Firstly the inflation, one committee member asked that given that the pandemic has fundamentally changed the purchasing habits of the customers like travel and outside dining has been completely abandoned in favour of groceries, are we even correctly measuring the inflation and should we even listen to such a flawed measure. Fed chief responded by saying that what the member is referring to is CPI where the constituents remain the same overnight whereas Fed’s preferred measure for inflation is Core PCE which gets updated every month in terms of its constituents. Even with constant updation, the Fed chief remarked that we are in such an unprecedented time (completely closing and opening the economy) that we need to be very humble about our ability to derive any signal out of it. Readers should pause and think about this humble admission. If Fed is not sure about the readings and signals, it belies that they will be much more cautious in raising rates.

Another question was on the sustainability of US debt and will the unfettered money printing lead to increase in influence of other sovereign powers. Fed Chief’s response to the question was interesting, firstly yes, the debt is unsustainable but the time to worry about it is not now. Maybe sometime later when the economy is fully recovered. Secondly, he sees no changes in the centrality of the USD in the world economy, the Dollar remains the world reserve currency by a distance. The reason for the same is the institutions which the US along with deep markets and full capital account convertibility. Now we have discussed multiple times in past the issue of reserve currency.

IMF economist Eeshwar Prasad discusses this issue in great detail in his book The Dollar Trap. He writes that for any currency to be a credible threat to the Dollar a deep and unfettered market to trade the country is a pre-requisite rather than an afterthought. Presence of such market for years will convince the participants that they can convert their Dollar holdings to a different currency and still sleep well at night. The technological developments though will nibble at the Dollars dominance bit by bit but that is a long-drawn process. Most investors hence even with a 10-year horizon can be reasonably confident of Dollar centrality. This thought if assumed correct has one major implication that Fed will continue with easy money longer than markets assume. Powell’s full testimony is available on Fed’s website and is a recommended watch.