Handling the Stronger Dollar

February 9, 2015

Deep economic concerns surround Japan, the euro area, and a number of emerging markets.  Monetary policies have been loosened in many of these countries.  In cases where interest rates have been lifted, the actions have not been a sign of economic normalcy but rather a step taken to stem capital outflows and defend currencies.  The United States stands in contrast as a place where the appropriateness of an interest rate hike for healthy reasons is coming into view.  A mid-2015 timing is back in play after the broadly solid January labor market report.  That would be just three FOMC meetings away.

A related question to examine concerns the ability of the U.S. economy to handle a rising trend of the federal funds rate.  In the year to January 1995 during which the federal funds rate was doubled to 6.0%, bond markets went haywire, with the ten-year yield rising some 175 basis point in just over three months and eventually poking briefly above 8.0%, real GDP slowed to 1.4% in the first half of 1995 from around 4% the year before.  Less bond market and GDP volatility accompanied the “measured” Fed tightening between mid-2004 and mid-2006, but that highly predictable operation quietly promoted speculation that led to the financial crisis and Great Recession.  Monetary transitions are difficult, and the coming one offers special challenges.

Short-term interest rates are not the only dimension of monetary conditions.  When a currency appreciates as the dollar has been doing, conditions become tighter for any given level of nominal interest rate.  An old rule of thumb for equating a change in the currency to a change in interest rates that would exert the same impact on inflation and growth is that the inverse of the ratio of trade to GDP represents the percentage change in the currency that acts like a 100-basis point rise of short-term interest rates.  U.S. imports equal 16.5% of GDP, and exports amount to 13.4%.  The inverse of their 15% average is roughly 7.  Since bottoming in May 2014, the dollar has risen slightly over 12% against a trade-weighted index of other currencies.  Divide 12% by the inverse of 0.15, and one is led to believe that dollar appreciation is already analogous to a 1.5-2.0 percentage point hike in short-term interest rates.

At the same, however, oil prices have been roughly halved, and the resulting lift to household disposable incomes and cut in corporate energy costs constitutes a significant offsetting stimulus.  Long-term interest rates are also lower, having fallen about 66 basis points on the 10-year Treasury and around 90 bps on the 30-year bond since the dollar’s low-point of 2014.  Inflation also has fallen, which raises the real cost of money associated with any nominal level of interest rate.  The personal consumption price deflator was just 0.7% higher in December 2014 than end-2013.  CPI inflation of 0.8% now compares to 2.1% back in May 2014. 

U.S. economic data have lately been rather mixed, suggesting that while the labor market is improving, such data overstate the U.S. economy’s ability to tolerate Fed tightening commencing a couple of months from now.  On-year house price inflation was 4.3% in November, the latest month reported by Case-Shiller, down from 13.4% at the end of 2013.  Factory orders posted successive monthly drops of 0.7% in October, 1.7% in November and 3.4% in December, with the most recent of these months showing similar declines in durable and non-durable goods.  Retail sales declined 0.9% in December, the most in 11 months.  U.S. national income account data for the final quarter of 2014 revealed

  • A halving of the real GDP growth rate to 2.6%.
  • A 1.0 percentage point drag on the 2.6% growth rate from net exports.
  • A quarterly 2.2%  slide in government spending that produced yet another calendar year drop in that component of demand, albeit of just 0.2%.
  • Softer non-residential investment activity.
  • A 0.8 percentage point augmentation of GDP growth from inventory building.  Without such, growth for the quarter would have been less than 2.0%.
  • Hardly any improvement in calendar year real growth, which was 2.4% in 2014 versus 2.2% in 2013 and 2.3% in 2012.
  • Continuing sub-5.0% nominal GDP growth.  GDP rose 3.7% on year in 4Q14 after 4.6% in 4Q13, 3.5% in 4Q12 and 3.6% in 4Q11. 

Finally, let’s look at the labor data.  Non-farm payroll jobs expanded 2.33% in the year to January 2015 but 1.74% in the previous 12 months and 1.56% in the year to January 2013.  Over the five years between January 2010 and January 2015, jobs climbed 11.1 million, a 1.66% annualized rate.  But here’s the rub.  From end-1979 through end-1999, employment advanced at a 1.83% per annum race, and the pace of each decade of that 20-year span also experienced growth of 1.83% in jobs.  1.83% thus constitutes a handy benchmark of long-term equilibrium growth in jobs.  For all but the last year of the current economic recession, the gap between trend full-time employment and the actual level of employment kept widening.  If employment since December 1999 had continued to post average growth of 1.83% per year, the current level would be at 171.521 million workers, 30.67 million above the level actually seen last month.  And while the recent much better tone of labor market data is commendable, it is also the flip-side of weaker labor productivity.  Non-farm labor productivity advanced only 0.8% in 2014 after advances of 0.9% in 2013 and 1.0% in 2012. 

An economy with labor productivity growth along such lines will not so easily shrug off the kind of dollar appreciation that is expected by many over the coming year.  This doesn’t mean the dollar will fail to keep churning higher.  Currency markets tend to overshoot, and the U.S. circumstances look much brighter than those of Europe and Japan.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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