The US Dollar's Resilient Recovery: A Complex Dance of Credibility and Data
The US Dollar (USD) has been on a rollercoaster ride lately, with its fortunes shifting like a yo-yo. It's like the currency is caught in a complex dance, where relief rallies are shallow, and the Federal Reserve's (Fed) credibility gap is a persistent partner. But what makes this situation particularly fascinating is the interplay between the Fed's policy and the data, which is the real star of the show.
In my opinion, the USD's recovery is a testament to the power of data. The US labor market is in balance, wage growth is in line with the Fed's 2% inflation target, and productivity growth is strong. These factors support the disinflation outlook, and the upcoming Q2 non-farm productivity data could be the key to unlocking the next chapter of this story. But what many people don't realize is that the Fed's credibility gap is a major obstacle to this recovery.
The Fed's credibility gap is like a shadow that looms over the USD. When Fed Chair Kevin Warsh failed to turn tough inflation rhetoric into credible policy, the market took notice. But comments from some Fed officials may have helped steady the ship. The drag to the USD from this gap has eased, but it's not gone.
One thing that immediately stands out is the limited scope for a sustained rebound in the USD. The currency is trading in line with interest rate differentials, and we see limited scope for a more hawkish repricing in Fed funds rate expectations. The US labor market is in balance, wage growth is consistent with the Fed's 2% inflation target, and Fed policy is restrictive, assuming a neutral rate of 3.00%.
From my perspective, the USD's resilience is a double-edged sword. On the one hand, it's a sign of the Fed's commitment to its policy. On the other hand, it's a reminder that the Fed is walking a tightrope. Given that services account for a much larger share of the US economy (around 80%), weaker services hiring argues for Fed patience. But the renewed pick-up in services price pressure suggests upside inflation risks have yet to fully recede.
This raises a deeper question: What happens when the Fed falls behind the curve? The disinflationary force from strong US productivity growth is a silver lining, but it's not a guarantee. The Employment Cost Index (ECI) wages & salaries, the Fed's favorite wage data, was 3.2% y/y in Q2, consistent with the Fed's 2% target given average annual labor productivity growth of 2.1%. But what if productivity growth slows? What if wage growth accelerates?
In my view, the USD's recovery is a complex dance, and the Fed is the lead. The data is the music, and the market is the audience. But what many people don't realize is that the Fed's credibility gap is a major obstacle to this recovery. The USD's resilience is a sign of the Fed's commitment, but it's also a reminder that the Fed is walking a tightrope. The story of the USD is far from over, and the next chapter will be written by the data.
