Currency Volatility Presents Another Problem in a Difficult Policy Environment

October 14, 2011

The factors that bolstered the dollar strongly in September abruptly shut down this month.  For one thing, a new calendar quarter, and one that oftentimes has not been a good one for the dollar, has begun.  Two, a string of better-than-expected U.S. economic data has created more than reasonable doubt that a recession is at hand.  Most important, general risk aversion related to the euro debt crisis has paused as investors wait for confirmation that more serious expressions by European leaders of their commitment to finding a solution are in fact now translated into credible action.  

The shift in dollar sentiment hinges on assumptions that remain shrouded in extreme uncertainty, such as the new consensus that a recession will be avoided.  It is natural for reported economic trends to wax and wane from month to month.  Actual readings tend to be more volatile than forecasts, and it’s not unusual in a given month for forecasting errors to have the same sign.  The forecasting process relies on extrapolation and data smoothing.  A month that happens to be better than trend is going to appear so in several respects, so a series of better-than-assumed results will cumulate.  It doesn’t mean that the following month or ensuing months thereafter will also produce better-than-expected results.  The pessimism about U.S. economic prospects in September was not based merely on the softness of monthly data.  Real GDP had already expanded in the first half of 2011 at a pace that was as low as any two-quarter postwar sequence not associated with a recession.  Worse labor market statistics and very soft income growth look ominous, and so do housing market conditions.  A very heavy dose of fiscal restraint lies ahead, not behind, and financial market conditions have been strained by the euro crisis.  Softening global demand will restrain U.S. exports.

Much can also still go wrong in the euro debt crisis.   From the inception in late 2009, the crisis has reflected shortcomings in regional politics more than regional economic fundamentals.  Political decisions are very hard to forecast and generate some of the most difficult markets to trade.  The original sin of European and Monetary Union was a failure to secure overwhelming voter support for a common currency and a single monetary policy.  Implications of EMU such as an eventual common fiscal policy were never well understood, and a common European culture never took root. Painful actions that must be undertaken to save the euro are still breeding resentment rather than reluctant acceptance that the medicine will set the stage for a better tomorrow.  The past history of the crisis has seen actions repeatedly taken too late and being insufficiently forceful.  Into this toxic mix, officials at the ECB now are warning that the kind of resolution now under exploration may compromise the central bank’s ability to maintain a strong currency in the future.

Considering the dubious nature of what has changed recently, the wideness of the dollar’s swings is alarming.  In September, the U.S. currency appreciated more than 10% against the Swissie, Kiwi, and Australian dollar and by at least 7% relative to the euro and Canadian dollar.  But from early October highs, the greenback has dropped back as much as 9.1% from a peak of AUD 0.9386, 7.2% from NZD 0.7466, 5.4% from 1.3144 per euro, 5.1% from CAD 1.0657, and 4.4% from CHF 0.9314.  Sterling, which fell 4.0% in August, recovered as much as 4.2% from its October low of $1.5221.  Life for the yen, which has traded this month between 76.30 and 77.48 per dollar, has been relatively steady, but Japanese officials remain dissatisfied with the unit’s level, which on net has appreciated slightly over 55% against both the dollar and euro compared to its average level in July 2007 just before the beginning of the global financial crisis.

This excessive sensitivity of flexible currencies to oscillating perceptions is playing an unconstructive role at a difficult juncture for the world economy.  One of the two parts of the G-7 and now G-20 mantra about currencies stipulates “that excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial policy.”  The other shared currency desire, that exchange rates be flexible and consistent with economic fundamentals, provides justification for limited government interference, while the highlighted first point indicates that officials are well aware that completely unfettered  currency trading will not always produce an optimal backdrop that promotes growth and price stability.  Having currency levels that are warranted is important, but so too is the need for limited volatility around equilibrium. 

So what can officials do if displeased by currency market conditions?  Countries being battered by punishing exchange rate levels and increasingly one-way exchange rate risks like Switzerland have been allowed to build a wall to block the market’s tendency.  A number of emerging markets have also been allowed to intervene against prevailing currency market pressures.  But Japan’s protest that its competitiveness has been eroded by a rising yen has not attracted sympathy because the currency has lately been comparatively stable and a rising yen seems appropriate in light of Japan’s deflation and weak money and credit growth.  Last but not least, trade tensions between China and the United States have escalated, and currency war seems imminent as Congress moves closer to passing a punitive tariff against imported Chinese goods.  As they did in the summer of 2008 when world financial market conditions took a big turn for the worse, Beijing officials appear to have halted the yuan’s managed appreciation pending clarification of global growth risks.  This collision course of U.S. and Chinese currency policies could mushroom into an enormous story as it pits the two largest economies against one another and the dominant reserve currency asset against the largest holder of debt denominated in that money.

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

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