Checklist of Economic Fundamentals Supports a Buoyant Dollar

September 17, 2014

Currency analysts approach the task of forecasting by reviewing a checklist of economic vital signs, the so-called fundamentals.  Likewise, when officials complain that their currency is either too strong or too weak, the argument is based on a grading system that considers around seven comparative measures of fundamental economic performance.  The ratings involve inflation, short-term growth, long-term potential growth, monetary policy, fiscal policy, the current account, and interest rate differentials.  On these various properties, the dollar appears well-positioned.

Inflation:  U.S. consumer prices fell 0.2% last month, cutting the 12-month increase to 1.7%.  Core CPI inflation (excluding food and energy) was also at 1.7%.  The CPI is not far from its 25-month average on-year which has been 1.6% overall and 1.8% on core.  Goldilocks would be pleased with these results, which are neither too high nor too low.  The Federal Reserve’s preferred measure of inflation, the personal consumption deflator is running further below a target of 2% at 1.5% overall and 1.3% core, and this reduces the urgency to raise interest rates sooner.  Euroland and Japan have lower than desired inflation, and the United States for many years in recent decades ran inflation that was chronically above inflation elsewhere.

Short-term Expected Growth:  U.S. real GDP exceeded 3.4% in three of the last four quarters and should be close to that figure in the current quarter as well.  In the latest poll of forecasters conducted by the Economist, projected U.S. growth in 2015 of 3.0% dwarfs the forecasts of 1.3% in the euro area and 1.2% in Japan.  Comparatively strong growth means that real U.S. interest rates will stay higher in the United States than elsewhere.

Long-term Growth Potential:  This depends on the expansion rates of labor and the productivity of labor.  Each of these variables will be climbing faster in the United States than Europe or Japan, where populations are shrinking, regulations are more cumbersome, and investment has lagged.

Monetary Policy:  Short-term interest rates since 2009 have been pinned near zero everywhere.  The Fed funds rate is unlikely to rise before March, but key rates will start normalizing sooner than in Japan or the euro area.  Quantitative monetary stimulus in the U.S. is about to end, but will continue in Japan and may yet be introduced soon in the euro area.

Fiscal Policy:  The U.S. budget deficit has narrowed in the United States far faster than predicted and is likely to be marginally less than 3.0% this year.  By disregarding the impact on demand, European governments that implemented much more severe spending cuts and tax hikes than the U.S. spun their wheels and achieved less progress consolidating their public finances at sustainable levels.

Current Account:  In the run-up to the Great Recession, the U.S. current account deficit equaled 5.2% of GDP in 2004, 5.7% in 2005, 5.8% in 2006 and 5.0% in 2007.  (By comparison, the deficit that hammered the dollar in the 1970s never surpassed 4.0% of GDP).  The deficit narrowed to 4.7% in 2008, then tumbled to 2.6% of GDP in 2009, 3.0% in both 2010 and 2011, 2.8% in 2012 and 2.4% last year.  This year it’s equaled 2.4% in the first quarter and 2.3% in 2Q.  It was not surprising when the deficit shrank in the recession, but the continuing smaller imbalance subsequently highlights a strengthening of U.S. export competitiveness that also is reflected in the nascent revival of U.S. manufacturing.  Euroland is running a sizable 2%+ current account surplus, but such is not distributed evenly across the common currency-sharing members.  Japan has a surplus too, but it is much smaller than it used to be in spite of yen depreciation.  Currency react to changes at the margin, and the U.S. current account situation is much better in a relative sense now than before.

Interest Rate Differentials:  Three-month U.S. money rates enjoy a premium of 13, 18, and 22 basis points vis-a-vis Japan, Euroland and Switzerland.  A more meaningful advantage of 201, 151, and 202 basis points, respectively, exists on 10-year sovereign debt yields against these three economies. 

Forecasting future currency movements is much more difficult than the above checklist would imply.  Many intangibles can and often do throw off a fundamentally-based prediction.  As the king of the mountain in outstanding reserve currency asset portfolios, the dollar is victimized by an ongoing desire of investors to achieve greater asset diversification.  As the presumed foreign policy leader among western nations, U.S. policy competence, success, and perceived judgement is constantly on trial.  Markets like decisive and strong executive leadership.  I imagine the dollar would have done well in the early 20th century under Teddy Roosevelt if the current floating market-determined international monetary system had been observed.  A quarter-century ago saw the dollar embark on a substantial and prolonged uptrend, based mainly on changing U.S. monetary and fiscal policy but also to a great extent on the world perception of renewed U.S. self-confidence under President Reagan.  Barack Obama’s geopolitical image is very different from either Teddy, FDR or Reagan.  True, Washington has been very involved in trying to fix geopolitical strains abroad in a way that promotes the interests of the United States and its Western allies, but U.S. objectives seem to be slip-sliding away.  An additional problem is the stalemated Congress that is seemingly paralyzed from taking a unified action to solve any kind of problem or threat. 

On the checklist of economic fundamental comparisons, the dollar looks good to go, but intangibles argue against betting the ranch on the dollar climbing sustainably in the fashion that it did in the early 1980s and late 1990s.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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