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Interest Rates, Inflation and the US Dollar
Economic Analyst: Luke Brown, Quinnipiac Global Economics Research Team
Every week my research team sends me their reports and I’ve been watching the reports from Luke Brown on the USD with some interest. A year ago everyone was talking about the dollar’s meteoric rise. Today, not so much. But there’s been a shift again recently for those who watch these things.
Weekly Reports and Recent Trends
As the weekly reports rolled in I noticed that some weeks the results were mixed, like this one from the beginning of May. Three end the week above 100 and two end below.
Source: Yahoo Finance and own calculations. Exchange rates are inverted to be USD per local currency (i.e., an increase indicates a stronger domestic currency) and then indexed to be 100 at the start of the period. AUD is Australian dollar, CAD is Canadian dollar, EUR is the Euro, GBP is the British pound, and JPY is the Japanese yen.
The way these are calculated, an increase represents a stronger currency relative to the USD (i.e., a weaker USD relative to that currency). This graph first caught my eye because on May 3rd, the US Fed raised interest rates. Higher interest rates should strengthen a currency’s value (i.e., strengthen the USD and make all these lines go down) but it didn’t seem to.
Markets are not mechanical contraptions with levers and pullies, they are the collection of private individuals making choices and exchanges based on their current knowledge, view of the world and expectations about the future. And that, in turn, means that most market movement is (a) nearly impossible to interpret accurately in real time and (b) reflects changes in expectations.
Here, one interpretation is that enough market participants expected a larger increase in the US Fed’s interest rate than happened. But, it’s very hard to know. I’m actually not a fan of trying to interpret in a meaningful way every up and down in a market price in real time. Nevertheless, interest rates do and should matter. We’ll return to that below.
As the recent weeks rolled by, I noticed some mixed weeks and also some down weeks, like the most recent graph for May 19 - 26. Everything ended weaker over last week which means the USD strengthened against all these currencies.
When weeks go by and more reports look like the May 19-26 report than the May 1-11 report and none have looked like the total opposite (i.e., all rising), it suggests that, on average, the USD has been strengthening relative to these currencies.
Luke’s historical plots suggests that this is indeed correct.
Source: Yahoo Finance and own calculations. Exchange rates are inverted to be USD per local currency (i.e., an increase indicates a stronger domestic currency). The center line is a rolling three-month average. The upper and lower boundaries are the average plus and average minus one standard deviation, respectively, for the same three-month period.
Notice that the ends of all of these series show a decline and that there is no period where they all uniformly rise. For much of April (middle of these graphs) most of them were rising – and the USD weakening – but it still wasn’t universal while the declines at the beginning and declines recently are across the board for sure.
My suspicion is that this reflects a growing view that the US economy is still growing strong and the US Fed will continue to raise rates. I know many Wall Street commentators are hoping the Fed will stop, but US data continues to suggest that the economy is strong and inflation still high.
The Fed may pause, but it won’t cut anytime soon and may even raise rates again. That should strengthen demand for USD and hence strengthen its value in world markets.
The BEA Report and Its Implications
On Friday, May 26th, the Bureau of Economic Analysis (BEA) – one of the US governmental statistics offices – released the latest “Personal Income and Outlays” report for April. It shows that (1) consumer spending rose instead of slowed and (2) prices rose as well.
This is a devastating report for those hoping the Fed was done raising interest rates. Overall it definitely says that the economy isn’t slowing as much as anticipated and, most importantly, that inflation is still higher than intended. Adding further weight to this particular report is that it is the one reporting the Fed’s preferred measure of inflation, the so-called core PCE Price Index.
The PCE – personal consumption expenditure – itself is one measurement of consumer spending. That is, it represents demand in the economy and it rose by 6.7% compared to last year while real GDP is only growing around 1.6%. That means the demand for goods is growing essentially 5% faster than the supply of goods. And, sure enough, inflation is around 5%.
The Fed was hoping higher interest rates would slow demand growth, keeping it growing more in line with supply and hence slowing inflation. But that’s not the case. The trend was moving in the right direction since Q1 2022 (see following graph of PCE vs real GDP) but that may be reversing.
The Fed wants these two lines to look like they did before Covid. Notice, pre-Covid, PCE was growing about 2% faster than real GDP. And, inflation was about 2% during that period (not shown separately on this graph…inflation is loosely the gap between the two lines or PCE growth - real GDP growth).
The trends were all moving in the right direction. We see the red line (demand, or PCE) declining and, more importantly, the gap between the lines closing. That means inflation should be slowing.
What’s interesting is the uptick in Q1 2023 real GDP at the very end. Yes, that closes the gap which is good. But it also suggests that interest rate hikes are not slowing the economy as much as the Fed expected or hoped.
The story here is all about predicting whether the Fed will hold interest rates constant or increase or even decrease them. If the Fed believes that real GDP (supply) can rise further while PCE growth (demand) slows, it would hold. That would be the “soft landing” everyone is praying for at this point. We’d get inflation down, but GDP, incomes and jobs would remain strong.
The problem is that, in aggregate, real GDP is what generates the real income consumers have to spend. Think about it. You earn your money by producing or selling something. That’s the supply side of the economy, real GDP. You use that income generated from your role in the supply side to go out and buy goods and services you want. That’s the demand side. For this reason, the Fed expects to see higher interest rates slow both real GDP and PCE. It would ideally slow PCE a lot, real GDP a little and then sort of re-set the two so they are closer to each other going forward.
The Q1 numbers suggest that’s possible but coming about very slowly. And this April report shows that PCE rose since last month. It’s now moving in the wrong direction.
To make matters worse for the Fed, it’s preferred measure of inflation, the PCE Price Index minus energy and food prices got worse! The Fed reminds us every chance it gets that it prefers “core PCE excluding food and energy” because food and gas prices are volatile. We’ll call it “core PCE” for short and it tells us more about true inflation.
The bad news for the Fed in April is that both the overall PCE and core PCE price indexes rose. And, since March, PCE excluding food and energy, is higher than PCE. That means food and energy prices have fallen but inflation in the rest of the economy has not. Broader inflation actually worsened over the last two months. We are back to our January and February numbers and worse off than we were in December, at least according to the Fed’s own preferred measure.
All this is just to say that the latest report is one more indication that the Fed’s inflation fight is not yet won. That means the Fed may raise interest rates further at their June 13-14 meeting.
At the same time, recent reports are also suggesting that Europe is entering a recession. The problem in Europe is that inflation remains around 7% but the economy is already slowing significantly. If the whole region is really pulled into a recession, it will complicate life for the ECB which should be raising interest rates further to fight inflation but lowering them to mitigate the recession.
Exchange Rate Conclusions
We started by talking about exchange rates. A country’s currency strengthens when, all else equal, its interest rate rises faster than the rates in other countries. This is because people want to invest in that higher interest rate country. To do that, they have to first buy the country’s currency and that drives up the value of the currency.
The strong US economy and persistent inflation suggests that the Fed will now, at most, hold interest rates constant at the next meeting or, with increasing likelihood, raise them again by a quarter point. The slow European economy and persistent inflation suggests the ECB will likely still raise rates, but now by less than originally expected so as not to worsen the recession too much.
That means, over the coming weeks and month(s), a likely slight strengthening of the USD relative to the Euro and other currencies of countries in a similar situation. Market participants may very well have been discerning this in the economic tea leaves in recent weeks which is why we’ve been seeing a slight strengthening in the USD. The next weeks will tell us a lot as more data comes out and as we near the Fed’s June decision to raise rates more or not.
Thanks again to Luke Brown for excellent reports and research support.
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 BEA, Personal Income and Outlays for April 2023: https://www.bea.gov/news/2023/personal-income-and-outlays-april-2023