On Theory, Case Improves for a Rising Dollar

July 4, 2013

Not since the subprime credit crisis began six years ago next month has the contrast between the Federal Reserve’s policy intentions and those of other central banks looked as striking as now. 

Led by Chairman Bernanke, a road map has been presented of possible reduced asset purchases starting as soon as September.  Bernanke claims such a move would not be tightening but merely less forceful stimulus.  But as anybody who drives a car knows, the application of less downward pressure to the accelerator results in a slower car speed unless one is traveling downhill, and that is not the environment at present for the U.S. or global economy.  Put differently, quantitative easing is a policy tool that affects monetary conditions.  Raising interest rates or reducing QE are two ways of making policy less stimulative.  In fact, talking in public about raising rates or reducing QE also lead to less stimulative monetary conditions.  Long term interest rates were given a big boost from Bernanke’s congressional testimony on May 22.  The Fed hasn’t acted yet, but a tightening of U.S. financial conditions is self-evident.

Tighter monetary conditions have also been imposed on other countries, since the rise in long-term borrowing costs has been shared widely, and this development has worried other central bankers.  Before the Fed revealed that conditions are shifting in a way that may prompt lessening U.S. quantitative easing, a new regime of leadership at the Bank of Japan made this year’s most dramatic policy adjustment.  Japan’s balance sheet, monetary base, and money supply show sharply accelerated growth.  Japan has left recession, the yen is about 20% weaker than last November’s level, and prices are transitioning to on-year positive change.  Japanese long-term interest rates have climbed along with other sovereign debt yields, but they remain below 1.0%.

The Bank of England and European introduced changes in policy communication today that officials there seem hopeful will counteract the impact on monetary conditions in their economies from the effect of the Fed’s early shift.  The BOE statement called the rise in British market rates inappropriately large, and ECB Pdt Draghi underscored that the ECB’s move communicates a downward bias in its interest rate that will remain for an “extended period of time.”  In a variety of smaller developed economies and commodity exports, currency depreciation is being tolerated and even encouraged in places such as Australia and New Zealand. 

Currency corrections offer the quickest way for these accommodative stances to insulate economies from the Fed’s very gradual testing of an exit strategy.  The fact is that Fed policy in absolute terms remains in historical terms extraordinarily loose.  The Fed’s initial actions will blunt U.S. economic growth only by means of outsized increases in market-determined shifts in the dollar, stocks, and long-term interest rates.  It will be hard for members of the euro area to decouple long-term interest rates from U.S. developments at least fully especially since market confidence has eroded in the political sustainability of austerity in the region.  An implicit message that has not been made explicitly by officials is that the Fed would welcome some dollar appreciation and ECB officials would favor some euro depreciation.

The currency Gods have complied very grudgingly so far, and that includes times well before Fed officials began to signal lessening need for quantitative easing.  The case has long existed for a softer euro.  One of the reasons why analysts were so sure last year that the euro would break up is that no politically feasible way to restore competitiveness to troubled members of the bloc is possible that doesn’t include a significantly depreciated euro.  Until now, that critical condition simply hasn’t fallen into place.  EUR/USD ended the first quarter at $1.2819 and was at $1.2862 when Bernanke testified in the second half of May.  The common currency closed not far from those levels today.  The euro also is 6.5% stronger now against the yen than it was at the end of the first quarter, and it has risen slightly against the Swiss franc as well since that base date.

The currencies that have moved downward most sharply have been the commodity-sensitive ones, and the driving factor behind that correction seems to be the stingy Chinese monetary policy, not what the Fed may or may not do.  In an effort to rebalance Chinese growth away from its massive reliance on investment, the monetary authorities are taking a chance on causing a hard landing there.  Such a risk has to be discounted in the price of currencies of countries that export heavily to the world’s second largest economy.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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