Managing the Dollar Through a Period of Policy Normalization

March 24, 2016

So far, so good. 

After years of running an extraordinarily loose monetary policy required by insufficiently high inflation, excessive labor market capacity, an inappropriately tight U.S. fiscal stance, and broken-down Washington politics offering no hope for a more balanced macroeconomic strategy, the Fed faces the challenging task of policy normalization.  It goes without saying that the process needs to be done gradually and that it threatens financial market instability that could potentially kill off the economic conditions that make lessening accommodation appropriate and necessary.  In the face of other monetary policies at the European Central Bank and the Bank of Japan, for instance, that are being loosened, one danger is that the dollar could spike, depressing U.S. import prices, preventing a timely return of U.S. inflation to target and sending global equities lower as is happening today.  An untethered dollar could also weigh on commodity prices and global aggregate demand.

Communication is playing the biggest role in the Fed’s approach to its delicate mission.  The rhetoric has been messy because pure consistency would be counter-productive.  Whether the average pace of rate tightening is 50 basis points or 100 basis points per year, it’s important that market participants not get comfortable with a pre-set linear path to a long-run normal federal funds rate level.  For one thing, nobody can confidently predict what that should or will be.  It would require perfect foresight about how the U.S. and world economies evolve, how financial markets handle the transition, and how their reaction feeds back into real economic trends.  Plus, any number of unforeseen shocks may disrupt that process. 

There is a second even more important reason why the Fed’s message has and will continue to bounce around.  By not presenting a message that tows a strictly straight line, wise use of rhetoric can limit toxic cumulating swings in the dollar, equities, commodities, and long-term interest rates.  The dire predictions of an 85% plunge this year in U.S. stocks or of a 25% appreciation of the dollar are more apt to happen if investors know with certainty the divergent paths of U.S. central bank rates vis-a-vis those of other major monetary institutions.  By not conveying an entirely transparent road map, the Fed has made a significant contribution to achieving a decent economic performance in spite of other damaging factors such as globalization and technological changes that render too many workers’ skill sets unmarketable.  Or, to name another example, leading U.S. politicians on the left and right are working the public into a paralyzing frenzy of despair and anger with accusations corrupt and utterly incompetent business and political institutions. 

And yet, with the Fed’s help, the United States avoiding the extremes of the Great Depression even though the triggering financial crisis was more severe than the one in 1929.  Progress is being made in absorbing labor market slack, with a 4.9% jobless rate that is half as much as at the peak.  Deflation was prevented in the United States.  On-year growth in the personal spending price deflator rose to 1.3% in January (and 1.7% in the core index).   The last six calendar years saw real GDP expand no less than 1.5% and at least 2.2% four times including 2.4% in both 2014 and 2015.  The U.S. had grown faster and done a better job of preserving a desired pace of inflation than other advanced economies.  The DOW and S&P 500 are each just 2.9% below their year-earlier level, and the 10-year Treasury yield is up on balance by a mere 3 basis points to 1.90%.  While some pundits continue to scream that the Fed has fallen far behind the curve, this is not a market acting as if it sees the whites of inflation’s eyes.

The dollar has strutted its volatility but to insignificant effect.  The U.S. currency has ranged between 1.1714 and 1.0520 against the euro over the past 52 weeks, but its New York opening today of $1.1036 was very close to its 12-month average $1.1153.  The Swiss franc traded in a 14% high-low corridor but is less than 0.5% from its one-year mean.  The dollar is 4.6% weaker than its yen mean to offset a 6.9% appreciation of the pound’s current level from its one-year average.  The greatest dollar appreciation has been at the expense of emerging market currencies.  However, the trade-weighted dollar is slightly below its mean.  The bottom line, moreover, is that the U.S. trade and current account deficits have not soared into unsustainable territory.  The effect of net foreign demand on U.S. GDP growth in the second half of 2015 was a marginal boost of 0.18 percentage point in the third quarter followed by a marginal 0.26 percentage point drag in the year’s final quarter.

Some market players and the politicians that want to return the United States to the gold standard will continue to complain about getting whip-sawed by  seemingly flip-flopping rhetoric from monetary officials, who change their tune like Charles Evans.  It’s not incompetence.  It’s just reacting to new information.  But it’s not entirely that.  There’s also an element of design, and it’s a good thing for markets and the economy.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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