The forex market turns to Powell and the Federal Reserve

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Are we seeing a shift in market expectations regarding Federal Reserve Chairman Jerome Powell and the Federal Reserve?

On Tuesday, Mr Powell testified before the US Congress in his bid to be renominated as Fed chair for another term.

During the day on June 10, the Monday before the testimony, the US Dollar Index (UDX) was above 96.00 for the day, at one point reaching 96.20.

During testimony, Powell reiterated the Federal Reserve’s recent story that inflation has become a problem for the Fed, although it may still be temporary in nature due to the impacts of the coronavirus pandemic.

He went on to say that the Fed was now reducing its monthly securities purchases from its recent monthly target of $120.0, which would bring the recent policy effort to a conclusion by March.

Following that, Powell added that the Fed would likely start raising its key interest rate and would, in all likelihood, raise that rate two more times in 2022.

Mr Powell said the Fed was concerned about the way inflation had risen and would certainly do something about it.

And, that was basically his testimony.

The value of the US dollar falls

The value of the US Dollar fell for the rest of the day and closed just above 96.00.

On Wednesday, new information on the inflation rate became public.

The rate of increase in consumer prices over the past year has increased to 7.00%.

It was faster than consumer prices had increased since 1982!

By the end of the day, the US dollar index had fallen to 94.95.

Near Thursday’s market open, the index had fallen to around 94.70.

But, Thursday morning, the news came out in the New York Times.

The headline read: “Lael Brainard to Call Inflation ‘Too High’ in Fed Nomination Hearing.”

Ms Brainard faces a congressional hearing today regarding her nomination as the new vice chairman of the Federal Reserve.

Clearly, the Fed feels it is time to put more emphasis on inflation and assure Congress and the financial markets that it is serious about combating the specter of high inflation and growing.

So right now Ms. Brainard and the Federal Reserve are pushing the argument to the level that the Fed will do something about the inflation problem that threatens the economy.

Problem

There is a problem with that.

Mr. Powell, Ms. Brainard and the Fed seem to have no real plan to fight inflation.

The most that emerges from this presentation is that there will be three increases in the Fed’s key interest rate this year.

Well, the president of one of the Federal Reserve banks admits that there will be four increases this year.

This would bring the effective federal funds rate to about 0.90% in the event of three increases and 1.5% in the event of four increases.

But little or nothing is said about what the Fed might do in terms of reducing the amount of reserves that exist within the banking system.

At the end of the banking week ending January 5, the commercial banking system held excess reserves of over $4 trillion.

The Fed has allowed the amount of reverse repurchase agreements to reach approximately $1.8 trillion, reducing the amount of excess reserves that sit in the banking system.

But if the whole point of fighting inflation is to reduce the reserves that are in the banking system, the Federal Reserve has a real problem.

If the Fed allows the number of reverse repurchase agreements to decrease, that means the amount of excess reserves in the banking system will have to increase unless the Fed starts selling securities from its portfolio and removing them from its portfolio. balance sheet.

The Fed faces a real dilemma.

Does it allow reverse repurchase agreements to stay as high as they are and just sell securities, or, in an effort to further balance its balance sheet, does the Fed sell securities from its portfolio while allowing reverse repurchase agreements to decrease at the same time.

We have heard very little about how the Fed will fight inflation by reducing the huge amount of liquidity it has pumped into the economy over the past two years.

Traders are aware

Traders in the forex market should be aware of this dilemma facing the Fed and see the dilemma facing it.

The problem is that if the Fed does not effectively reduce reserve balances in commercial banks, inflation will continue and since US inflation appears to be worse than that faced by other major regions of the world, the value of the US dollar must fall against other major currencies.

If the Fed refuses to start withdrawing reserves from the banking system, a whole different picture emerges.

This picture includes a declining stock market, a possible second recession and further political unrest in the United States.

The Federal Reserve, under the leadership of Mr. Powell, tried in every possible way to avoid creating a stock market decline and economic disruption.

The Fed Powell has always tried to err on the side of not making a mistake that would hurt the economy. That is why we are in the situation we find ourselves in today.

In my opinion, traders in the forex market recognize this fact and that is why the value of the US dollar seems to be falling. This is a different picture from the one that was drawn in the fall of 2021.