A Modest Proposal
August 14, 2014
Tomorrow will mark the 43rd anniversary of the most famous event in modern currency market history. I refer to former President Nixon’s decision to sever the dollar’s link to gold. The dollar devalued four months later in a vain attempt to reestablish fixed parities. A second dollar devaluation followed 14 months afterward in February 1973, and when that didn’t work either, the era of floating dollar rates began in March.
Now that inflation differentials between countries are so narrow, the most popular model for predicting currency changes puts greatest emphasis upon differences in central bank monetary policies. But practice hasn’t conformed well to theory. Earlier this summer, the dollar embarked on an upward trend against the euro based on anticipated further Fed tightening while the ECB and perhaps the Bank of Japan moved toward more accommodation. In the past week, dollar strength has stalled, and its levels against both the euro and yen are only marginally different at this writing from levels a week ago.
Economic data by a wide margin has arrived weaker than expected to a greater extent than on the top side of forecasts. Is this the kind of backdrop that central bank, including the Fed, are apt to be tightening? On balance during the first half of this year, U.S. GDP went up about 2% annualized. Growth in the euro area climbed barely 0.5% annualized, and Japan’s economy stagnated on balance. Trends in emerging markets have been mixed, but the most important of such, China, just reported a bunch of disappointing data, notably very weak bank lending.
Even if the United States continues to outperform other economies, it may be imprudent for the Fed to disregard global developments. Inflation increasingly is a function of global monetary policy and economic growth rather than domestic variables. Supposing the Fed does start raising its Federal funds rate in the spring of 2015 in line with current conventional wisdom, doing so in a very gradual manner as advertised would merely replicate the ill-fated policy of 2004-2006 that led to asset bubbles and other conditions that fostered the Great Recession. The Fed’s current critics not only maintain that current policy is laying the seeds for asset price and real goods and services inflation but also depressing the strength of the U.S. recovery. A purer test of whose policymaking credentials are serving the world better – Yellen’s or her relentless critics – maybe the Fed ought to try the recipe of the hawks and get from here to there quickly. In market parlance, this would be getting ahead of the curve and seeing what the U.S. economy is really capable of doing freed of artificial support. Regardless of the result, such an experiment would settle the toxic dispute between monetary policy hawks and realists.
Markets do not this modest proposal will be tried, and they surely think it would be reckless. That’s the message of a dollar struggling to reach 1.30 per euro. Even more revealing, long-term interest rates are going south, not north.
August is a time to vacation, not trade. Markets can be volatile this season, but movements can prove unrepresentative of underlying forces. It’s best to see what happens after Labor Day.
Copyright 2014, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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