Last week the Federal Open Market Committee announced they were embarking on the first tightening cycle since December 2015, when the Fed began raising the Federal Funds Rate before lowering rates again in the summer of 2019. Fed Chair Jerome Powell reiterated during his press conference that the Fed was prepared to hike rates and was projecting numerous rate increases in 2022, provided the economic data support the need to continue tightening monetary policy.

Article by Steven Van Metre from our premium news partners at The Epoch Times.

Powell even indicated the FOMC discussed and was preparing to unwind its massive balance sheet of U.S. Treasury and Mortgage-Backed Securities that it has purchased on and off since the Great Financial Crisis. Yet, Powell and the other committee members seem completely unaware of the massive policy mistake they are making by tightening monetary policy.

Unbeknownst to the members of the FOMC, there is a massive dollar shortage. By itself, a dollar shortage is deflationary and will ultimately lead to a much slower rate of consumer price growth that is more in line with the Fed’s long-term target of two percent. Due to persistent supply chain shortages created by the pandemic that is being exasperated by Russia’s invasion of Ukraine, consumer prices remain stubbornly high.

As the economy reopens and supply chain constraints ease, consumer price growth will slow considerably. Tack on a persistent dollar shortage, and it’s likely sometime later this year that consumer prices may even fall below the Fed’s long-range expectations. The risk Powell faces by tightening monetary policy during a period of high inflation and a dollar shortage is shoving the economy into a recession.

While a recession would be unwelcome, it would certainly achieve the Fed’s objective of squelching inflation. The challenge for policymakers is they cannot see a dollar shortage until it is too late. By the time they realize there is a global shortage of dollars, the economy is crashing headfirst into a financial crisis, or a recession, if policymakers are so fortunate.

The easiest way to tell there is a dollar shortage is through the U.S. Dollar itself and the bond market. Since May 2021, the dollar has steadily gained strength as other currencies have weakened. While a rising dollar is not enough to indicate a dollar shortage, it is a warning sign as the dollar tends to rise in value when there are not enough dollars to go around.

To make matters worse, the Fed has ceased its Quantitative Easing program, which led to the forced creation of bank deposits, and it has started raising the Federal Funds Rate. On their own, each should lead to a stronger dollar. Notably, the dollar started rising in value before the Fed begin to taper its balance sheet in November 2021 and has continued higher ever since.

The entire purpose of tightening monetary policy is to reduce aggregate demand. One way to reduce demand is to raise the value of the dollar, which can be achieved by raising the Federal Funds Rate. While the dollar does not rally every time the Fed increases policy rates, it tends to rise more often than not.

When interest rates rise, it discourages investment in the real economy and encourages an increase in savings. As more dollars find their way into deposit accounts where they sit idly, the value of the dollar increases. Yet many professional money managers believe tighter monetary policy leads to a weaker dollar but that is far from the truth.

New dollars are created when a new loan is originated by commercial banks. Consumers have a predisposition to borrow more money when rates are low than they do when they are high. By raising interest rates, the Fed seeks to reduce aggregate demand by increasing borrowing costs. As fewer new dollars are created by the commercial banking system, the value of the dollar should rise.

Despite the facts, investors and professional money managers are convinced the dollar is going to weaken. To profit on a weaker dollar, they are choosing to sell or short U.S. Treasury securities to drive the value of their price down. Bonds are nothing more than future dollars, so an investor or money manager will bet on lower bond prices to profit on a weaker dollar.

In doing so, these bond vigilantes have created a disconnect between the value of the dollar and bond prices. Normally, the value of the dollar and bonds have a strong relationship as one is just a deferred version of the other. But there are times—such as now, and much of 2018—where the dollar is headed higher while bond prices are falling.

In a dollar shortage, the dollar will continue to rise in value. Those who are betting on a weaker dollar by shorting or selling bonds will eventually learn just how interlinked bonds are to dollars. While bond prices have suffered one of their worst two-year periods in history, a rising dollar suggests bond prices are soon to skyrocket in value just like they did in 2019 and into early 2020.

It makes sense that bond prices should rally as new dollars are needed to ease the tightening financial conditions created by a stronger dollar. With the creation of new dollars, the only way to ease financial conditions when the Fed is tightening, interest rates must come crashing down to spur lending demand. When interest rates crash, bond prices will shoot higher.

Unfortunately for the Fed, they lack the tools and ability to fix a dollar shortage. This is why a recession is inevitable when the Fed attempts to tighten during a dollar shortage. In the end, interest rates will crash and bond prices will soar as the dollar continues to head higher until either the financial system breaks or the financial conditions ease.

Image by Gerd Altmann from Pixabay.