A Fed Policy to Promote Dollar Depreciation

September 24, 2010

Since mid-2007, worsening global economic news had tended to support the dollar, which benefited from inflows of funds seeking safe parking.  That metric broke down in the third calendar quarter, which ends next Thursday.  Thursday will also mark the midpoint of the Japanese fiscal year.

Many recent developments had potential to promote risk-reducing trading strategies.  Economic prospects are sufficiently precarious that several policymakers at the Federal Reserve are contemplating the resumption of quantitative easing.  Economic momentum in Britain and Euroland slackened fairly markedly at the start of the third quarter, and Japanese officials became sufficiently worried about their outlook to break a 6+ year hiatus from conducting currency market intervention.  Central banks in Australia, New Zealand, Korea, Norway, Sweden and Brazil, which had begun to normalize interest rates, have paused doing so or suggested flatter paths of rise in the future.  Europe’s fiscal imbalances and the health of the region’s banks are still weighing on investor sentiment, and Euroland’s peripheral members continue to grapple with painfully wide bond yield premiums.  Record high gold prices are about 12% higher than in late July.  Middle-east tensions are again elevated, and the frustrated anger of people in most advanced economies is showcased by the generally low voter approval ratings for political leaders.

The dollar has racked up cumulative losses, nonetheless.  Nearly four months have passed since the euro bottomed at $1.1878 on June 7, and the dollar has lost about 12% subsequent to then.  It’s down 16.6% against the Swiss franc and 16% relative to the Aussie dollar from respective highs of CHF 1.1730 and 0.8068 per AUD.  There has even been a 10% loss since late May’s 1.4232 per pound sterling high.  Not once since midyear has the dollar traded as high as ninety yen, and it lost around 2% against Japan’s currency this past week in spite of the surprise massive intervention on September 15 and follow-up sale of additional yen done today.  Against other currencies this week, the dollar by 13:30 GMT today had fallen by around 3% against the euro and Swiss franc, 2.3% against the Australian dollar, 1.3% relative to the kiwi, 1.1% against sterling and 0.9% versus the Canadian dollar. 

World economic prospects are better off with the dollar again depreciating rather than strengthening as it did earlier in 2010.  The U.S. economy is a lynchpin whose fate will determine whether most advanced economies can avoid a second recession next year.  Net exports have exerted a drag on overall U.S. growth in three of the last four reported quarters, including one of 3.4 percentage points annualized in this year’s second quarter.  3.4% also happened to be the current account deficit’s size relative to nominal GDP that quarter, up from 3.0% in 1Q10 and 2.4% a year earlier.  To avoid another financial market catastrophe, it is imperative that countries with large external deficits or surpluses trim those imbalances sharply and enduringly.  A weaker dollar would also likely be a more effective way to ease U.S. monetary policy than expanding the Fed’s balance sheet through outright purchases of Treasury securities.  When the yen strengthened early this year against the dollar, it rose even more sharply against the euro and many other currencies which were falling against the U.S. currency at that time.  Even if Japanese intervention accomplishes no more than holding the yen level against the greenback, it could relinquish ground against other currency units against which the dollar is now dropping.

The dollar’s extra losses this past week only seem counter-intuitive through the Alice-in-Wonderland lens of the past three years in which bad news for world growth has spelled good news for the dollar.  In a different, more conventional era, the FOMC statement this past Tuesday would have truly clobbered the dollar.  The new wording serves notice that it is the policy of the U.S. central bank to achieve a rise in inflation.  That’s a stronger statement than a promise to prevent negative inflation.  The United States doesn’t have deflation, nor is deflation the baseline forecast of Fed and private-sector analysts.  Prices are rising, but officials are arguing that they will do what is necessary to achieve a faster pace of rise in the future.  Such a pledge was not made in the early 1960s, when the CPI rose only 1.1% per annum during the Kennedy years.  From that point, inflation accelerated to 2.9% per annum while Johnson was President, 6.2% per annum under Nixon, and 7.0% during President Ford’s short watch.  Inflation hit its zenith in the Carter era, averaging 10.4% per annum over the four years he was president.  The darkest moment in U.S. management of inflation came in a prime time address by President Carter on October 24, 1978, when he basically attributed the problem to high U.S. interest rates.  Higher interest rates were an extra business cost, so the logic went.  But investors were dumbfounded by what they’d heard, and the dollar got murdered in Asian trading that was already under way when the president spoke.  One week later, the White House back-pedaled with a dollar rescue program that included a full percentage point hike in Fed interest rates and enlarged resources to fund intervention.  Fed Chairman Miller was replaced by Paul Volcker in August 1979, and a full war on inflation began two months after that.

Time will tell if September 2010 will be remembered as a key turning point the way that the Fed’s adoption of money targeting in October 1979 has been.  U.S. CPI inflation slowed to 4.2% per annum in the Reagan and Bush41 years, 2.6% in the Clinton era, 2.4% during Bush43’s term, 1.8% so far under Obama and 1.1% most recently.  Core inflation of 0.9% is even lower at present, and the Fed is saying enough is enough to the falling trend.  A central bank that’s willing to subordinate all other goals and to accept any collateral damage in pursuit of a weaker currency and higher inflation ought to succeed.  That’s far more than what the FOMC is signaling, and officials are not in complete agreement on what should be done next.  But an extraordinarily rare step was taken, and it’s one with negative implications for the dollar, all other things the same.  Ceteris Paribus, Latin for “all other things the same,” is a common device in economic models, necessary for analytical simplification but a conditions that never really holds.   Currency values respond to an infinite number of potential factors of which monetary policy is just one, but an important one.  The fact is that the dollar is much weaker now than when the serious effort to restore price stability began 31 years ago. 

One other fact of contemporary currency life is that all the governments would like to have an undervalued currency.  It’s not possible for each to succeed, but officials will respond to undue rises of their currencies given the disinflationary forces already in place.  Japan’s intervention has not been as successful as Japanese authorities would like, so traders need to be on guard for new and unexpected tactics in how that intervention is administered.  Swiss officials earlier this year had a bad experience with inflation, but now that the franc has crossed dollar unity, further appreciation would become more painful to absorb.  A strengthening euro magnifies the difficulties of Euroland’s weaker economies, some of which are in or near recession.  And then there is China.  The renminbi advanced 0.3% against the dollar last week, less than in the prior week, and is up 7% at an annualized rate since a more “flexible” forex policy was announced just over three months ago.  Since before a 2.1% revaluation in July 2005, China’s currency has risen on average by 4.2% per annum against the dollar.  China’s external surplus is not as vast as it was, but it is again growing and far too big.  Tensions between Beijing and Washington are again boiling over this and several other disputed issues. A protectionist turn of events would likely reflect poorly on the dollar against freely convertible currencies.

U.S. politics remains a wild card at least through yearend.  Not only is the configuration of Congress in doubt, but so too are the power of the grassroots Tea Party movement and what gets decided about the Bush tax cuts.  Currency traders have much to ponder.  The noise of daily volatility could drown a sense of trend, but directional shift could mount to something significant in the final quarter.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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