The Fed is Noticeably Behind the Curve



The USD has been pulling back since its peaked in December. Moreover, the greenback has declined markedly since the CPI release yesterday, which showed inflation increasing at its fastest pace in 40-years. The pullback in the greenback may be a function of the "buy the rumour, sell the fact" phenomenon. I.e., markets are forward-looking, and FXCM's USDOLLAR basket accelerated its momentum upwards as far back as September last year. The green trendline shifted to a steeper gradient (the orange trendline) as momentum increased. The blue vertical marked the higher trough of the increased momentum, which was validated by the higher peak at the end of September. Now that the strong inflation is apparent, the market is selling off the dollar, to the point that the orange trendline is being threatened (aqua rectangle).

Past Performance: Past Performance is not an indicator of future results.

The Monetary Policy Lag

Given that this is the fastest pace of inflation since the 1980s, the below chart is informative. The top chart is the US inflation series, the middle chart is its RSI, and the bottom chart is the federal funds rate as a proxy for general monetary policy. The blue vertical lines indicate an overbought condition in the US inflation series. The blue rectangle is the current overbought condition. It is no surprise that the early 80s also show as overbought, given that the current rate of change in inflation is similar. Of interest, June 1989 and March 2000 show overbought conditions as well. So, there are 3 obvious overbought conditions in the inflation RSI before the current reading. On each of those three occasions, the federal funds rate had already been hiked by the Fed i.e., monetary policy was already contractionary (green rectangles). July 1974 is outside our period, but it shows similar. Noticeably, this is not the case this time. This time the Fed is behind the curve.


Past Performance: Past Performance is not an indicator of future results.

Possible Reasons For the Lag

One may argue that the pandemic was an exogenous shock to the system that has been strong enough to alter normal monetary policy trajectory. Another reason might be the change of measurement by the Fed in meeting its price stability mandate. At Jackson Hole in 2020, it announced a target of an average rate of 2%, as opposed to an absolute target of 2%. Moreover, the unlimited QE may have caused some damage to market mechanisms regarding the demand and supply of long-term bonds. Market expectations suggest that inflation is likely near its apex. However, keep in mind that the current monetary policy experiment is still ongoing as the Fed now looks to normalise a bloated $8.8tn balance sheet. I.e., variables may be present that were absent before. This may impact on the transmission of economic information. As such, the current selloff in the USDOLLAR may provide an opportunity i.e. a potential "buy the rumour, sell the fact" moment as hypothesised above. As such, we continue to monitor.

Featured Image by Steve Buissinne from Pixabay

Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.


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