Foreign Exchange Insights: Fed Comments On the Dollar

November 25, 2009

Federal Reserve officials are not responsible for exchange rate policy.  That falls under the Treasury’s jurisdiction.  Thus it was the Treasury that engineered the dollar devaluations of December 1971 and February 1973, which ended dollar-gold convertibility and the era of fixed dollar rates against other major currencies.  Fed officials seldom comment on the dollar, but there it was in the third paragraph on page eight of yesterday’s released minutes from the November 3-4 FOMC meeting.

The FOMC minutes convey two thoughts about the dollar.

  • The first is explanatory regarding the greenback’s depreciating trend, characterizing such as a reversal of prior gains as haven-seeking capital first entered the United States and then was redeployed abroad when financial market conditions improved.  Both moves were “orderly,” a loaded word in the Fed lexicon going back to the earliest days of floating rates to describe when intervention or other actions to influence the dollar are appropriate.
  • The second message is forward-looking, implying the risk that continuing depreciation could intensify and/or boost inflation.  The situation will be monitored and, as Bernanke previously had implied, become policy considerations if the risks turn into actualities.

When market conditions become disorderly, they lose depth, breadth and resiliency.  Large commercial trades cannot be transacted without moving rates.  Bid-ask spreads widen, and financial intermediaries shirk their risk-assuming role.  Currency risk loses its normal two-way nature, movements become increasingly one-directional, and their is a tendency, acknowledged by the FOMC, for the movement to accelerate and detach itself from the flow of new information over time.  More important, a falling dollar may boost inflation and long-term interest rates.  From the earliest days of floating exchange rates when Treasury officials needed a framework to decide when to intervene, the guideline has been to do so when market conditions are deemed “disorderly,” and there is a whole checklist of properties to make that determination a little more objective and less subjective.  In practicality, the acid test has been to act when currency market strains spill over into other financial markets, and that clearly has not happened as long-term interest rates remain low amid benign expected inflation over the coming two years.

Note that intervention or other policy changes to influence currency movements are mostly governed by the rate of market change, not the market level.  The Plaza Accord was a notable exception, as G5 officials in 1985 agreed to sell dollars because a high dollar then was seen to be exacerbating imbalances in current accounts.  But even when the issue of market order is paramount, cumulative currency movement always tends to be large by the time that officials decide to resist a trend.  Two pointson this need to be made.  The dollar is presently weaker than it was on August 8, 2007, a day before the onset of the financial crisis.  The greenback is 6% softer than then against the euro and 27% weaker against the yen. 

The second fact is that the dollar has been in sliding mode most of this decade.  Since the end of 2001, it has depreciated 41% against the euro and 33.3% against the yen.  The greatest dollar crisis since the currency floated occurred in 1976-78.  Although the dollar did not fall as far then as it did over some other periods of weakness, that decline was interwoven with accelerating domestic inflation and elicited the most dramatic policy response, a full 100-basis point hike in the Fed’s key interest rate on November 1, 1978.  At that point the mark was 35% lower than early in 1976, and dollar/yen had tumbled 41% from a December 1976 high.  Note that these losses were in the same ballpark as the dollar’s present cumulative drops since end-2001, only with the amounts switched between the yen and mark/euro. 

From the standpoint of letting an extensive cumulating decline of the dollar continue uncontested, the last eight years represents one of the biggest examples of benign currency neglect.  Big dollar holders have a right to complain, but nobody advised them to create such large long dollar exposures.  In any case, the Treasury, not the Fed, will have the last word, and the interesting thing there is the swelling call for Secretary Geithner to be replaced as a sacrifice to double-digit unemployment that occurred on his watch.  Among other things, a new Treasury Secretary would create an opportunity to tweak the Obama Adminstration’s policy on the dollar.

Happy Thanksgiving, Everybody!

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.


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