The Doomsday and Mini-Doomsday Inflation Scenarios

The #FederalReserve's #FOMC met this past week, and the results are relevant to us in the #coffeemarket, and indeed all of the #commodities.

There were two big takeaways from the communications last week that were somewhat contrary, but the market interpreted them as #bullish the #USdollar. I think that bullishness may be unwarranted in a small way (the mini-doomsday scenario) and also I want to highlight what the Big Risks are here (the doomsday scenario).

First, I'll recount what happened, and why the dollar interpreted them bullishly, then we will get into the doomsday stuff. Here's what the #Fed said:

1) #Inflation is expected.

2) Rates will be raised (but not too soon).

Regarding 1--The Federal Reserve has prepared us to expect inflation. This is unsurprising given the dramatic increase in the #MoneySupply (+31.5% M2 in over the last 18 months), in increase in inflation indicators such as the CPI and also the increased media attention to inflation over the last several months.

From a basic #economics point of view, inflation follows from an increase in Money Supply. When #supply is abundant of a good, that good's relative value is less. So in the case of US dollars, when dollars are scarce they are worth more--one US dollar buys more goods. When dollars are abundant, they are worth less--one dollar buys less goods. This is the explicit intention of the Fed's Open Market Committee (FOMC).

What is a little bit more surprising, is that the Federal Reserve has said that they approve of this inflation.

This is in apparent direct contradiction to part 1 of the Federal Reserve's dual mandate: to keep inflation at 2% (the other being to keep unemployment at 4-6%). The justification for allowing inflation to be above 2%, is that it was under 2% during the #Covid #recession (as people lost jobs, had less money to spend, and there was less demand for goods while we were stuck indoors), therefore the FOMC elected to let inflation rise above 2% for some time to balance this out. Low inflation in 2020 plus high inflation in 2021 and make it a 2% average "over the longer run". That's the thinking anyway, we will see how this influences our doomsday scenario in a moment.

Item 2 communicated by the Fed is that interest rates will be raised.

The Fed raises interest rates to reduce the money supply (or taper the increase) and more members are supporting this rise in interest rates then before, thereby increasing its certainty. Some had previously seen forestalling the interest rate increases until 2024, so this is why the US dollar has reacted bullishly (gaining 2.5% on $DXY in 3 days!). Additionally, the statement included language that they could "adjust the stance" of monetary policy to react to current conditions.

My mini-doomsday scenario is this: That gain of 2.5% is based on a theoretical tapering 18 months hence. If that is the case, there is still a lot of bond buying/money supply increase between then and now and so in theory the dollar could start to fall again as the reality of that sinks in. The inflation according to the CPI over the last 3 months averaged 3.5% per month. That could undo any reactionary dollar gains in just a two short months.

However, the real doomsday scenario is not if the current average monthly inflation continues a bit above 2%, but if the TRAJECTORY of the rate of increase continues. In the last 4 months, inflation has risen on average 3.5% per month--above the 2% target, but not Weimar Republic either.

However, the trajectory is an average MoM increase of 1.1% (1.7% in Feb, 2.6& in Mar, 4.2% in April and 5% in May). If this rate of increase were to continue, we would see double digit inflation by the end of the year.

The Money Supply is a notoriously blunt instrument. The Fed by their own admission has said that they don't really know what's going to happen and that "we need to see more data".

If there is any inertia in CPI from the increase in Money Supply, then it is possible that this rate of increase could continue. If there is any doubt about the economic recovery, things will be even worse because then the Fed will be stuck with a tough choice between allowing inflation to continue, or throwing the economic recovery into jeopardy.

What does this mean for the coffee market and commodities?

There is substantial risk of inflation, and therefore higher commodity prices across the board. Coffee is facing the largest #Arabica #deficit in more than a decade, if there is an inflation problem, that is some serious kerosene to pour on this bullish fire.