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Pushing on strings

This is a big week for the dollar as the Fed gets a second opportunity to explain what exactly Flexible Average Inflation Targeting means. Right now, I think the market is still a tad confused by the absence of clear AIT parameters post Jackson Hole.

We all understand what the AIT means for the future: The Fed will stay lower for longer when the unemployment rate falls. They will not hike rates until actual inflation has been above 2% for a while. This shift from proactive to reactive is well understood. For example, the Yellen Fed clearly would not have hiked in late 2015 under this framework.

What is not well understood is what the change in the framework means for Fed policy right now. Does it mean they need to immediately become much more accommodative in order to get core PCE above 2% ASAP and make up for years of downside misses? Are they going to make a credible promise to act irresponsible and aggressively drive inflation expectations higher? Or will they just slowly and smoothly move from stabilization to accommodation, signaling the new framework is only relevant down the road?

I think part of the USD rally post Jackson Hole is the result of the market getting more and more twisted up and confused about whether the new framework changes Fed policy now or only in the future. To get credibility on the inflation overshoot, Powell & Co. need a bit of shock and awe this week. Otherwise, it all starts to feel like BOJ part deux.

The biggest problem for the Fed is that they have nearly run out of channels through which to loosen financial conditions. P/E expansion has already been dramatic. Spread compression in corporate credit is near its theoretical limit given the ongoing waves of corporate default (I think?). Interest rates are very close to zero all the way out the curve.

The Fed is mostly pushing on strings at this point. Fiscal policy and the evolution of COVID-19 are much more important drivers of US growth and inflation than Fed policy. Given the lotto ticket trade is for a dovish Fed, not a hawkish one, I would think USD weakness and equity strength continue into Wednesday.

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