Current Accounts Matter, Too

November 9, 2015

Across-the-board improvement in last Friday’s U.S. labor market statistics lifted the dollar as high as 1.0706 per euro.  That’s a net gain of over 6.0% since October 21.  Expectations are now strong that the federal funds rate will be raised next month and that ECB monetary policy will be eased as well.  It’s not often that the world’s two most influential central banks shift stance in opposite directions during the same month. 

The Fed’s isolation has been accentuated by other developments.  The Bank of Japan Board left its quantitative stimulus settings unchanged last month but cut forecasts of growth and inflation.  Last week saw the publication of more dovish-than-expected quarterly reviews by the Bank of England and Reserve Bank of Australia.  There’s no urgency to tighten as soon as possible in the U.K., and RBA officials still consider more easing possible.  In October, the People’s Bank of China reduced its main interest rate, now 4.35%, for the sixth time in 2015.  Projected U.S. growth according to a new OECD Outlook released today of 2.4% in 2015, 2.5% in 2016, and 2.4% in in 2017 easily exceed forecasts for GDP growth in the eurozone, Japan and the whole OECD bloc in all three years.

The dollar, nonetheless, has not recovered all the way back to its 2015 highs of 1.0459 per euro touched in March nor JPY 125.86 hit in June.  Dollar/yen has been pretty trendless and is within a single yen of its mid-2015 level.  Despite the divergence in monetary policy directions, the 3-month deposit rate spreads between the U.S. and Euroland has widened just 13 basis points since end-June.  The U.S.-Japanese spread is just eight basis points more advantageous now than then.  In comparisons of 10-year sovereign debt spreads, the U.S. advantage has increased merely four basis points against Euroland and by two bps against Japan since mid-year. 

Under these circumstances, one might expect the dollar to have strengthened more sharply than it has.  Current account disparities are an important factor behind the dollar’s stickiness.  The U.S. current account has a deficit equal to around 2.5% of GDP, while both Japan and the eurozone are projected to run surpluses of between 2.5% and 3.0% of GDP.  Switzerland has a surplus around 8% of GDP.  In Canada and Great Britain, whose currencies have struggled lately, the current account deficits equal around 3.0% and 4.5%, respectively. 

The velocity of Federal Reserve monetary tightening over the next 6-12 months will be influenced by the performance of the dollar and U.S. labor market conditions.  The monetary stance can become less accommodative either as result of rising interest rates of dollar appreciation. The latest evidence of dollar-induced drag is not setting off alarms.  Net foreign demand during the third quarter only exerted a 0.03 percentage point drag on economic growth, which slowed to 1.5% annualized mainly because of negative 1.44 percentage point contribution from inventories.  Moreover, September’s goods and services trade deficit was $7.2 billion less than October’s gap because of a 1.6% on-month advance in exports.  Regarding labor costs, analysts reacted Friday to news that average hourly earnings growth accelerated in October, jumping 0.4% on month and 2.5% on year.  However, a more tepid picture emerged in today’s monthly labor market conditions index, which the Federal Reserve compiles.  Such printed in October at a lower-than-forecast 1.6, thus only matching its third-quarter average value.  The LMCI touched a low of -0.7 seven months ago but remains closer to that trough than to its readings of 7.4 in December 2014 or 4.0 last January. 

If the LMCI turns more sharply higher in coming months, Fed officials will likely become less prepared to trade off appreciation for a higher federal funds level.  However, such a scenario does not seem the likeliest because of the aforementioned current account disparities that favor other currencies over the dollar.  Note, too, that the Fed generally watches a trade-weighted dollar composite index rather than key bilateral relationships that are widely traded.   

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

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