Covert Currency War Games

May 3, 2016

Even with U.S. monetary stimulus being throttled back and other central banks pressing harder on the stimulus pedal, the pace of policy change thus far and in the future will be too gradual to make a huge difference in a direct way through their influence on short- and long-term interest rate differentials.  The cutting edge of policymaking is being channeled through indirect avenues, particularly by influencing foreign exchange rates.  The Reserve Bank of Australia caught investors by surprise today, cutting the official cash rate by 25 basis points to a record low of 1.75%.  With lower-than-anticipated domestic Australian inflation of 1.3% in consumer prices and 1.2% in producer prices last quarter, plus subdued global inflation as well, Australian monetary officials could afford a more stimulative macroeconomic policy to buttress growth that has been sputtering.  Lackluster demand, production and price pressure is a common story around the globe. 

Moving in infrequent increments of 25 basis points as Australia’s central bank just did is hardly going to goose GDP expansion much.  The previous 25-basis point cuts were implemented in May 2015, February 2015, and August 2013.  To the credit of Australian policymakers, the interest rate cut was complemented by a more stimulative fiscal policy, as the government revised its projected budget deficit significantly higher from the estimate made a half-year ago.  Unfortunately, fiscal policymakers in Europe, Japan and the United States are letting monetary policy shoulder a much greater burden that such can effectively manage.  Politicians are ideologically opposed to public-sector deficit spending, even though experts on public finance widely agree that fiscal support is the only way that the global economy can emerge from its current malaise.

All that is not to say that the Australian central bank or other central banks that are easing are doing so entirely in vain.  The Reserve Bank’s surprise official cash rate cut elicited an immediate drop in the Aussie dollar.  But a problem with currency manipulation is that it’s a zero sum game.  One currency’s depreciation is another’s appreciation, mitigating any boost to aggregate demand.  A second drawback is that like other forms of trade protectionism, depreciating one’s currency encourages retaliatory counter-actions in other countries, and the net result can be ever-increasingly volatile financial markets.  In this age, when every institution is assumed to be rigged, it’s easy for investor confidence in financial markets to reflect fundamental forces can be jeopardized.  As confidence wanes, so will the depth, breadth and resilience of the marketplace, causing the drop in confidence to be self-fulfilling.

The dollar has been a recent loser in the currency merry-go-round.  The dollar is now 9.2% weaker than its 2015 euro high of $1.0459, and it has lost 15.6% from last year’s peak of JPY 125.86.  The dollar finished the month of April with an 88.05 reading on its trade-weighted index, 6.8% below its end-2015 level but hardly changed in year-over-year terms since the U.S. currency had strengthened before its recent bout of weakness.  Paradoxically, the dollar has softened even as other financial markets have been gripped by intensifying risk aversion.  The ten-year Treasury yield, now at 1.79%, is a half-percentage point below its level when the only federal funds rate hike thus far was announced last December 16, and it is even 32 basis points lower than its year-earlier. level.  Falling long-term U.S. interest rates and a weaker dollar outweigh the restraint of a quarter-percentage point increase of the Fed’s short-term interest rate target.  Yet U.S. real economic growth has decelerated from 3.9% last spring to 2.0% in the third quarter, 1.4% in the final 2015 quarter, and 0.5% in the first quarter of this year, so the number of interest rate hikes in 2016 envisaged by Fed officials when they launched rate normalization last December has had to be trimmed considerably.

Gold is benefiting from the softer dollar as it often does in such circumstances.  Gold has risen 20.7% so far in 2016 and recently touched $1,300/ounce for the first time since January 2015.  That’s still far from the yellow metal’s alltime peak slightly above $1,900 in August 2011.  And given the tail-chasing nature of currency war games, it’s doubtful that the recent downtrend of the dollar will endure anywhere long enough for gold to make substantial inroads into the gap between its current price and the historical high.  A wild card is oil, which is much less sensitive to movements in the dollar than gold.  West Texas Intermediate oil has climbed around 17% this year and 22% since the Fed’s rate hike in December.  Even so, oil remains 26% below its year-ago level.  Among the main reasons why U.S. and global growth have trended more weakly than anticipated is that the cheapening of oil from the summer of 2014 into early 2016 never stimulated personal consumption and business investment as many economic models had predicted.  Oil is a wild card not just because analysts are unsure where its prices will next go but also because the linkage between changes in the price of energy on the one hand and real and nominal GDP on the other is less well understood than thought.

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

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