Bolder Official Efforts to Influence Currency Movements

September 25, 2014

Officials outside the United States had for some time been frustrated by the weakness of the dollar in spite of superior U.S. fundamental economic comparisons of real growth, labor market conditions, and interest rates.  Now that the Federal Reserve’s third round of quantitative easing is wrapping up and speculation is heating up about an initial hike of the federal funds rate, governments are taking a more proactive approach to securing a stronger dollar.

An upward turn in the dollar in fact began about a half year ago.  Since peaking in mid-March, the trade-weighted dollar has appreciated at an annualized rate of about 9.5% to its highest value since just before mid-2009, and the trade-weighed euro in the same span has declined at a roughly equivalent pace.  The trade-weighted yen fell around 6% annualized.  Sterling and the Canadian dollar have gained about 5.5% and 2.5% in trade-weighted terms but are each now roughly 5% weaker than their strongest dollar levels of 2014.

One might conclude, being that since the dollar is now strengthening, that foreign officials would be satisfied to keep a low profile and let market forces do their thing and extend the trend.  The logic for instead promoting dollar appreciation even more actively, although not intuitive, is quite sound.  Empirical examination of the effectiveness of historical manipulations of foreign exchange values illuminates three truths.  The first is that direct and verbal intervention yield best results when deployed as a reinforcing mechanism, that is only after economic fundamentals favor the currency direction sought by officials.  Some fundamentals may appear to justify different currency market conditions than one observes, but until exchange rates actually trend in the desired direction, governments cannot be sure that the totality of economic fundamentals are aligned in their favor.  Just over 29 years ago on September 22, 1985, Plaza Accord was released by the finance ministers and central bank heads of the Group of Five.  The statement called for a broadly based decline of the dollar to address imbalances in world current accounts.  The plaza accord was reached not at the dollar’s lowest point, reached six months earlier on February 26, 1985, but rather at a time when a turnaround in dollar values from those lows had become well established.

A corollary of this first truth is that it helps immensely for governments to be adjusting their fiscal and monetary policies in a way that is consistent with their exchange rate offensive.  The second finding is that currency manipulation is less effective done unilaterally than when part of an effort involving several governments.  The Japanese and Europeans are not coordinating their actions with each other or with the Fed, but it helps that that the policies of each are shifting, and the actions are not at cross-purposes.

A wide range of official actions and comments have signaled official dissatisfaction about currency values and, in turn, reshaped currency market psychology.

In September 2011, the Swiss National Bank introduced a cap on the franc’s strength at 1.2000 francs per euro, which was a weaker than the prevailing cross rate at that time.  Although this asymmetric franc still has a range cap of 1.2000, a quarterly review of policy published a week ago expressed the policy in more emphatic terms.

The economic outlook has deteriorated considerably. The Swiss franc is still high. With the three-month Libor close to zero, the minimum exchange rate remains the key instrument to avoid an undesirable tightening of monetary conditions. The SNB will therefore continue to enforce the minimum exchange rate with utmost determination. For this purpose, it is prepared to purchase foreign currency in unlimited quantities. If necessary, it will take further measures immediately…. For Switzerland, the risk of deflation has thus increased again. As in the previous quarter, the forecast is based on a three-month Libor of 0.0% over the next three years, and expects that the Swiss franc will weaken over the forecast horizon.

The Czech National Bank since November 2013 has used a similar currency policy to the Swiss, preventing with actual and threatened intervention any rise of the koruna beyond 27 per euro.  The Czech National Bank adopted an exchange rate target because with interest rates effectively at zero, there was no other way to manage overall monetary conditions.

Once Japanese Prime Minister Abe came to power in late 2012, a weaker yen became a center-piece of Abenomics, the overall strategy to end deflation, boost import prices, stimulate exports, and lift overall aggregate demand in Japan.  Yen depreciation was not presented as a final policy goal, but Japanese officials observed that depreciation is a natural by-product of the necessary policy changes to eliminate deflation and said that restored and predictable Japanese inflation of around 2% was in the best interest of the Japanese and world economies.  The yen’s low today of 109.39 is 30.5% below the peak in 2012 of 76 yen per dollar, yet Bank of Japan Kuroda denied today that further depreciation in response to better U.S. fundamentals “won’t itself be a negative for the Japanese economy.”

ECB President Draghi has been pledging to do whatever it takes to avert deflation and has increasingly expressed concern about falling short-term inflation expectations and the impact that a prolonged period of low inflation might have on medium-term expected inflation.  Euro depreciation boost import costs and provides perhaps the quickest-delivered positive effect on inflation of the unconventional monetary tools that the ECB is using.  Moreover, there’s nothing outside the ECB’s legal mandate about market-induced euro depreciation.  Make no mistake, a main object of the almost daily barrage of comments from Draghi is to provoke a drop in the common European currency’s external value.

Minutes from the Reserve Bank of Australia’s September Policy Board meeting leave no doubt that further depreciation is sought of the Aussie dollar after a drop so far of 26% against the U.S. currency since the peak in 2012.  The text notes, “the exchange rate remained above most estimates of its fundamental value, particularly given the declines in key commodity prices and, overall, had offered less assistance to date than would normally be expected in achieving balanced growth in the Australian economy.”

The piece de resistance from a central bank encouraging market players to exchange its currency for U.S. money comes from a paper by the Reserve Bank of New Zealand entitled Why the NZ Exchange Rate is Unjustified and Unsustainable.  A media release summarizing the arguments boldly states

The level of the exchange rate is unjustified when it is inconsistent with the economic factors that typically explain its movement during the business cycle. It is unsustainable when it deviates from its long-run equilibrium level, where it would be expected to settle when business cycle factors have fully dissipated.  The Bank’s analysis indicates that the real exchange rate is well above its sustainable level, and also above levels justified by short-term business cycle factors.  Unjustified and unsustainable are important considerations in assessing whether exchange rate intervention is feasible.  Governor Wheeler said that past experience suggests that, when the New Zealand dollar begins declining from an unjustified and unsustainable level, the ultimate adjustment can be large.

U.S. officials have pretty much stayed quiet about the dollar’s recent gains.  For now, appreciation does not appear threatening.  The U.S. trade balance and export growth have not reacted adversely.  A rising dollar will suppress inflation, allowing Fed officials to raise interest rates very gradually.  Dollar strength won’t hurt Obama’s battered reputation further.  On the contrary, the presidents during the two eras of multi-year dollar strength — Reagan in the early 1980s and Clinton in the late 1990s — were popular.  At both times, a rising dollar was perceived as a vote of market confidence in the long-term outlook for the U.S. economy.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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