Can’t Get There from Here

May 6, 2011

This has been a very volatile and ultimately strong week for the beleaguered dollar.  Compared to the period’s lows, the dollar at 14:20 GMT on Friday had advanced by 3.0% against the euro, 2.4% relative to the kiwi, Australian dollar and Swiss franc, 1.9% against sterling, 1.6% versus the Canadian dollar and 1.2% against the yen.  Some correction of the dollar seemed overdue, and it benefited from five factors:

  1. The ECB’s failure to signal a high probability of a June interest rate hike.
  2. Perceptions of a greater policy commitment to support the U.S. currency.
  3. More investor risk aversion.
  4. The death of Osama Bin Laden at the hands of a successful and daring U.S. military raid.
  5. The mounting risk that some European sovereign debt may be restructured.

The above developments do not build a foundation for an enduring dollar reversal.  Macroeconomic policy prospects are little different now from the end of April, nor is the economic outlook materially changed in the major advanced economies.

If the ECB doesn’t boost interest rates next month, the delay will most likely be a mere month.  In fact, several more increases from a highly accommodative 1.25% refinancing rate appear inevitable at the ECB over the rest of this year and in the first half of 2012.  Structural differences between the U.S. and European labor markets make the latter comparatively more susceptible to second-order inflationary effects.  Even if the ECB had a dual mandate like the Fed, officials there would have to respond more hawkishly than their U.S. counterparts to the commodity price shock.

The United States economy continues to emerge from recession in fits and starts and at an overall sluggish pace.  The upturn has been fed by an extremely loose Fed policy, and continuing expansion without that support remains in some doubt.  The U.S. economy has not one, but two, weak Achilles tendons.  Housing is again slumping, and the labor market must climb the steepest of mountains before resembling its old self.  The chatter found in financial markets misguidedly discusses these problems less than those of inflation and public sector deficits.  Consumer prices accelerated at a 6.1% annualized rate during the first quarter after 3.9% in 4Q and 2.2% in 3Q10, but on-year inflation of 2.7% in March was similar to a 2.3% per annum pace over the past five years and 2.5% per annum in the preceding two sequential five-year periods.  The 12-month core CPI inflation rate in March was 1.2%, down from a five-year per annum rise of 1.8%, and five-year rates of 2.0% in 2001-6 and 2.4% in 1996-01.  In contrast to this pretty stationary and acceptable trend, there were 0.9% fewer jobs in April 2011 than in April 2001 versus jobs growth of 18.7% in the ten years to April 1991 and 22.1% in the ten years to April 2001.  The lengthening long-term nature of  U.S. unemployment underscores its structural as well as cyclical nature and belies the possibility that the economy could be poised for an inflation problem anywhere close to as intractable as experienced in the 1970s.

A vastly changed U.S. economy will not be able to handle the kind of steady normalization of monetary policy assumed by dollar bulls.  One has to wonder further if tightening monetary policy can coexist with deep cuts in the fiscal deficit, both near term and long term.  The original sin of the fiscal problem was household debt.  Without consumers spending way beyond their means, the boom and bust of the housing market would not have occurred.  Financial markets would not have reached unsustainable extremes.  A recession might have developed but not the biggest post-WW2 worldwide slowdown.  Real government spending rose only 1.1% in the year to 1Q10 and then even less in the ensuing year to 1Q11, just 0.2%.  The fiscal deficit ballooned because the recession whacked revenues.  Reducing the deficit exclusively through spending cuts will not undo a spending spree in recent years because that spree didn’t happen.  It will instead take the economy to a wholly different place than it was and create a heavy drag on growth along the way, just as it is doing already in Britain. 

In such circumstances, it will be hard for the Fed to tighten.  Think of Japan’s experience.  The federal funds target has been at 0.5% or less for a full 2-1/2 years, but the Bank of Japan’s key interest rate has been at or below that threshold since September 1995.  Waiting for Godot to appear can take a lot longer than anybody imagines.

Only lip service has so far been paid to the virtues of a hard dollar policy.  Concerted intervention in March was directed at capping the strong yen, not rescuing the dollar.  Bernanke all but said that the dollar would not get special policy attention.  He wants a healthy dollar but maintains that the way to promote such is by pursuing the central bank’s dual mandate, which indeed was the justification for QE2.  The economy but not the dollar performed well while the second round of quantitative easing was implemented.  ECB officials welcome dollar-supportive rhetoric from their U.S. counterparts but are not going to halt rate-tightening because of the risk of euro appreciation.  Meanwhile, the only explicit U.S. policy of currency manipulation concerns the Chinese yuan and seeks a weaker dollar level against that currency.

As a low-interest rate currency, the dollar benefits at times when investors shun risk.  However, the risk-on/risk-off pendulum has been very fickle and is not something upon which to base a long-term currency projection.  Likewise, Europe’s sovereign debt woes have been festering for a considerable time already, at times weighing significantly on the euro.  But the euro has prevailed on balance, often marching to the beat of its fundamentally strongest elements rather than to an average of all 17 components or those which are most weakly endowed.

The raid on Bin Laden’s hide-out was a positive factor for the dollar for many reasons.  It helped restore U.S. self-confidence and America’s image around the world, while boosting President Obama’s approval ratings.  The government was daring in its willingness to undertake the challenging operation, and the plan’s execution and preparation fortified confidence in the military and intelligence agencies, which at times had been flagging.  This was the antithesis of the failed April 1980 rescue attempt of U.S. hostages in Iran or, more recently, the bungled responses to Katrina and the Gulf oil spill.  The death of Bin Laden brought immediate and significant relief to oil prices and dampened other commodity spikes, which had been weighing on the dollar.  But this development did not change the basic supply and demand issues that have been buoying commodities.

I expect the relentless forces of diversification to grind away at the dollar.  From lows in 2010, the U.S. currency has lost 25% against the Swiss franc and Australian dollar, 18% against the euro, and 15% against the yen.  Transitory periods of strength are to be expected after moves of such size.  More upticks may lie ahead particularly if equities suffer the kind of late-day weakness that were an almost daily event in 4Q08 and 1Q09.  But the dollar’s greatest long-term risk seems to lie to the downside.  Whether one contemplates a multi-year upturn of the dollar or a return to full labor market health as seen in the 1980s and 1990s, the conclusion seems to be the same:  “You can’t get there from here.”

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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