E-piphany

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Today I want to mention two disturbing trends – one of which may have some minor implications for inflation.

The first is the six-month downtrend in the US Dollar (see chart, source Bloomberg).

I’ve included the last several years’ worth of pricing for the broad trade-weighted dollar so as to help avoid any alarmist conclusions. While the trade-weighted dollar is down more than 7% since the beginning of 2017, it is unchanged on a trailing-two-year basis and still quite a bit above the level of three years ago. Moreover, as I’ve mentioned before – when the question concerned the effect of the dollar’s rise on inflation – the dollar doesn’t have a huge impact on US inflation. The US economy is much more closed than, for example, the economies of the Eurozone, the UK, or Switzerland – while the US is a major trade partner for virtually every country in the world, exports and imports as a percentage of GDP are less important than they are for most other countries in the world. Consequently, while movements in currency pairs will cause the declining currency to absorb more of the joint inflationary impulse of the two countries, the effect is fairly small in the US. A 15% dollar appreciation over a two-year period is associated with roughly a 1% deflation in core goods, nine months later, which is close to where core goods inflation has been (actually between 0 and -0.8% for the last few years). Core goods themselves are only about ¼ of core inflation overall. Since the dollar’s appreciation or depreciation has almost no discernable effect on core services a 15% dollar appreciation over two years only nudges core CPI down 0.25%.

So the effect is not large. However, it’s worth noting when the two-year rate of change goes from +16% (which it was one year ago) to 0%. This should start to add incrementally to core goods inflation, and provide a small upward lift to core inflation over the next year or so. But that assumes the dollar does not continue to slide. Continued dollar weakness might be attributed to the US political situation, but it isn’t as if most of our major trading partners are experiencing striking political stability (UK? Europe?). But dollar weakness could also be associated with a reversal in the relative hawkishness of the US Fed compared to other global central banks.

The run-up in the dollar corresponded with the end of Quantitative Easing in the US in 2014, combined with the continuation of QE (and more to the point, LSAP) in Europe and Japan. As hard as it is to think of Janet Yellen as being a hawk, on a global, relative basis her Fed was comparatively hawkish and this helped push the dollar higher.

Which brings us to the second disturbing trend, which may help to explain why the dollar is weakening: commercial bank credit growth has slowed markedly over the last year. The chart below (Source: Enduring Investments) shows the year-over-year change in commercial bank credit, based on data reported by the Federal Reserve.

The current y/y rate of credit growth, at 3.4%, is a number much more consistent with recession than with expansion as the chart above illustrates. To be sure, it is hard to see many overt signs of weakness in the domestic economy, although auto sales have been weakening (see chart, source Bloomberg) and they can sometimes be an early harbinger of economic difficulties.

It is also worth noting that credit growth hasn’t translated into slower money growth – M2 is still rising at 6% per year – so there is not an implication of slower inflation from the deceleration in corporate credit (at least, so far). But, between the suggestion the dollar is making that Federal Reserve policy may not be as hawkish going forward as the market had assumed, and the interesting and possibly disturbing sign from slowing growth in corporate credit, I’m starting to become alert for other early signs of recession.

Of course, the dollar’s slide might instead indicate that the ECB and/or BOJ are about to become less dovish, more rapidly than the market had expected. While core Euro inflation has been a little more buoyant than many had expected (1.1% in the last release), it seems unlikely to drastically change Draghi’s course. However, I will keep an open mind on that point. I’m not saying a recession is imminent; I’m just saying that I’m starting to watch more carefully.