Ceteris Paribus

March 28, 2017

Forecasting the dollar has been infinitely complicated by all the crazy stuff going on in U.S. politics, other populist movements, and changing policies. In theory, current economic conditions and their projected trends ought to be front and center in this process, but that’s far easier said than done. To simplify things when constructing predictive models, economists employ a device known as ceteris paribus, which in Latin means treating every conceivable factor not directly considered in the model to be unchanging and not pertinent to the result. For the sake of this note, let’s basically just consider a few very basic U.S. economic variables.

GDP Growth: The U.S. economy is said to be in a new normal, but the truth is that the transition from previous norms to a new equilibrium does not appear to be yet completed. The sequence of calendar year rates of average growth in the current upswing shows real GDP advancing 2.5% in 2010, 1.6% in 2011, 2.2% in 2012, 1.7% in 2013, 2.4% in 2014, 2.6% in 2016 and 1.6% last year. That works out to seven years of 2.1% average growth, including three years of 1.7% or slower expansion and none with growth of more than 2.6%. We’ve already got one more calendar year in this upswing than the previous one, but that expansion had a marginally faster average pace and included four consecutive years that saw GDP rise more quickly than in any of the years of this expansionary business cycle. An even more impressive cycle of expansion in the 1990s endured over nine consecutive calendar years of 2.7% or faster growth, including seven years when GDP climbed at least 3.6%. And for seven years starting in 1983, U.S. real GDP increased 3.5% or more.

Labor Productivity: Long-term non-inflationary economic growth is governed by the trends in hours worked and output produced per hour. U.S. labor productivity has imploded during the recovery from the Great Recession. Productivity grew 2.8% per year on average from 1947 until 1973, the last year before the first oil price shock. In the ensuing period of elevated inflation from 1973 to 1990, productivity was halved to 1.4% per year, but it revived back to a 2.4% per annum pace in 1990-2007. Since the financial crisis, productivity has risen just 1.1% a year on average, and the last five full calendar years have been even worse. In no year from 2012 through 2016 did productivity expand as much as 1.0%, and the average yearly increase was only 0.6%. Not only has the growth of real GDP slowed progressively over the last four business cycles, but the essential prerequisite for long-term expansion and halting the decelerating momentum is non-existent.

Inflation: Measured by the core personal consumption price deflator, inflation has been positive, not especially volatile, and unexpectedly low, with calendar year increases of 1.2% in 2009, 1.3% in 2010, 1.5% in 2011, 1.9% in 2012, 1.5% in 2013, 1.6% in 2014, 1.4% in 2015, and 1.7% last year. The Federal Reserve considers 2.0% as most ideal, neither deflation-prone nor inflation-prone and providing the best support to economic growth, ceteris paribus.

Current Account Deficit: The U.S. deficit, a principal focus of Trumpenomics, has been stable and manageable during the present upswing. In past expansions of this length, this has not been the case. As a percent of GDP, the deficit amounted to 2.7% in 2009, 3.0% in both 2010 and 2011, 2.8% in 2012, 2.2% in 2013, 2.3% in 2014, and 2.6% in both 2015 and 2016. Based on precedent, shortfalls of this relative size do not pose a singular problem for the dollar in most circumstances.

Long-Term Interest Rate Differentials: Currencies tend to be affected more sensitively by interest rate spreads on longer maturities than shorter ones. The 10-year Treasury yield is 2.41% now, up from 1.84% on average in 2016 and a mean of 2.21% in 2015. Relative to German bunds, the Treasury’s 203-basis point premium is up from calendar year means of 170 basis points in 2016 and 167 bps in 2015. Compared to 10-year Japanese JGBs, the current spread is 236 basis points versus means of 189 basis points last year and 185 bps in 2015. In the past two years, long-term sovereign yields moved together in greater tandem than has been the case this year. So while the U.S. economy has become less dynamic from the standpoint of real and nominal GDP growth as well as labor productivity, the interest rate factor is lending the dollar more theoretical support especially since the current account gap isn’t widening unduly.

The trade-weighted dollar has not posted meaningful cumulative movement. One measure compiled by the Fed printed last Friday at 93.67, which was down from 96.50 at the 2017 high on January 3 but still above the 92.08 level on last November’s Election Day. It was even lower at 88.71 last August 18. The euro at $1.0807 today is very close to its average levels of $1.1097 in 2015 and $1.1069 in 2016. In contrast, the dollar has trended higher against sterling which is now at $1.2452 versus calendar year means of $1.5284 in 2015 and $1.3547 in 2016. The dollar fell considerably from a mean of JPY 121.04 in 2015 to JPY 108.72 in 2016 and, at JPY 111.1 at present, has recovered only a small part of that loss. So the dollar has been pulled differently depending on the currency against which one chooses to measure it.

There’s no ceteris paribus in the real world. We’re navigating through times when political leadership is unpopular and responsive mainly to the corrupting force of money. Nationalism is rising, and technology is pushing the envelope in ways that depress, rather than enhance, productivity and competition. It is reasonable to wonder if democracy can retain credibility in a cyber-dominated world so susceptible to fake information. A U.S. government like none before it, unchecked climate change, Brexit’s challenge to the European Union, and the continuing possibility that China’s economy may yet tip over into a hard landing within the next year or two pose enormous uncertainties for investors seeking predictability.

When the task of forecasting the dollar seems overwhelming, the truth that may be most useful to grasp is that a political leadership viewing all matters through a protectionist lens will be most pleased with a currency that is becoming more competitive via depreciation. In protectionist times, currencies of countries with current account deficits generally do not fair well in the long run. That would be convenient.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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