Fed Policy, Dollar Policy and Trade Policy

August 20, 2019

Among the most consistent themes of Donald Trump from his time as private sector businessman through his candidacy for president and since becoming president of the United States is the view that the country is competing on an unfair trading playing field. Surpluses are good regardless of context. Deficits are bad, and  tariff wars can be won by the United States with minimal collateral damage. Meanwhile, currency depreciation in an environment where global inflationary risks are skewed to the downside and domestic inflation is chronically below its mandated target offers the most powerful tool for enhancing the price competitiveness of U.S. exports and domestically sold goods that compete with imports. Not surprisingly, therefore, the Trump Administration has been rhetorically more outspoken than any U.S. government since Jimmy Carter’s in complaining about dollar overvaluation, although there thus far has been no actual U.S. currency intervention in which the Treasury or Fed sell dollars for foreign currency explicitly for the purpose of weakening the greenback.

Trump’s complaint that overly tight Federal Reserve policy is responsible for the strong dollar and sub-potential economic growth cannot be corroborated by comparing the current configuration of its interest rate target, inflation, growth, and unemployment with situations around mid-2007 and mid-2000. Why pick those base dates? They represent times, which like now, were deep into the previous two business upturns when U.S. growth began to show signs of slowing down.

  • The federal funds target was reduced in June by 25 basis points to 2.0-2.25% and is widely expected to be cut again at September’s meeting. On-year CPI inflation averaged 1.7% during the first seven months of this year, just 55 basis points below the funds rate target range ceiling. GDP growth averaged 2.6% in the first half of this year with the weaker of the two quarters at 2.1%, and the jobless rate is presently 3.7%.
  • In the first half of 2007, the federal funds rate was 5.25%, 255 basis points above CPI inflation, which averaged 2.7% during January-July that year. GDP growth in the first half of the year averaged 1.7%, with the weaker of the two quarters being only marginally positive at 0.2%. The jobless rate was 4.7%, a full percentage point higher than now.
  • In the first half of 2000, the federal funds target of 6.0% was 270 basis points above CPI inflation, which averaged 3.3%. GDP in the first half of that year averaged 4.5%, but the weaker of the two quarters was only 1.2%. Unemployment of 4.0% was higher than now even though the non-inflationary long-term jobless rate has dropped considerably since 2000.

Those earlier two instances came before the great recession and thus before the Fed and many other central banks introduced unconventional tools of monetary stimulus. Put altogether, the Fed was running a much tighter stance in mid-2000 and mid-2007 than now, and it did so in spite of higher unemployment than now or recent quarters with much lower GDP growth than experienced this past spring.

It is true that the dollar has strengthened, and this tightens monetary conditions for any given level of interest rates. However, much of the appreciation occurred before the start of this year. The trade-weighed dollar (TW$)  against the currencies of other major advanced economies with which America trades is just 0.5% firmer than at end-2018. Since a low in the spring of 2011, however, the TW$ has advanced 36%, but it also remains nearly 38% weaker than its floating rate era peak in February 1985. It has also risen about 9% over the past year and a half — all during President Trump’s stewardship — and this no doubt irritates him.

It’s one thing to wish for a weaker dollar but much harder to make that so when swimming against the current of non-supportive economic fundamentals. Parts of Continental Europe are already in recession, presenting the European Central Bank with an even more valid reason than the Fed in which to ease policy. Fiscal policy in Germany ought to be looser, but that’s also out of Trump’s control. Japan is the bellwether of the weak growth with deflation syndrome and remains symptomatic nearly three decades after the onset of the problem. Japanese real GDP expanded 1.2% between mid-2018 and mid-2019 after 1.5% in the previous statement year, and on-year core CPI inflation there has been 1.0% or less since March 2015 versus a 2% goal. Chinese growth is slowing and will do so even more sharply if Trump escalates his trade war. Britain is diving with eyes closed tight into Brexit, and this choice will affect many other countries adversely as well.

U.S. long-term interest yields have declined more sharply than their German or Japanese counterparts. From November 12, 2018 through today, 10-year sovereign debt yields dropped 164 basis points (bps) in the United States but 109 bps in Germany and 36 bps in Japan. One might think that with such a squeeze on favorable U.S. rate differentials that the dollar would have depreciated. But in fact, interest rates, capital flows and exchange rates are determined simultaneously in the marketplace, and the conclusion to draw is that the dollar would likely have appreciated more sharply if not for the greater change borne by long-term interest rate differentials.

The most influential policy impulse of 2019 has not been unleashed by either fiscal policy or monetary policy. Instead, sporadic threats of higher U.S. tariffs in 2018 graduated into real barriers being imposed, eliciting the predictable retaliation in kind from America’s trading partners and also generating the typical decline in two-way commercial flows. In a more globalized world, this trade war if not contained could have an extra propensity to disrupt because supply lines are more internationally woven than was the case in previous major trade wars.

President Trump is right to postulate that the United States will probably not be hurt as much as more openly trade-dependent economies in a trade war. He’s wrong to think the U.S. will be barely impacted and to assume that any all-out trade war will lead to quick capitulation by the other side. Like military conflicts such as the American Civil War, WWI, Vietnam, or the War in Afghanistan, trade wars tend to be much more damaging and longer lasting than promised initially by politicians.

The uncertainty associated with a trade war, whether all-out or with punches pulled favors havens from geopolitical risk. Gold is one, and among paper currencies so are the yen and dollar. A rising dollar would undermine Trump’s ultimate objective of shrinking the U.S. trade deficit. So if a trade deal can’t be struck, it seems just a matter of time before the United States engages in currency market intervention. Such operations will likely be unilateral, because Washington has few remaining friends when it comes to commercial relationships.  Based on past experience, three important conditions are needed for successful FX intervention: 1) intervention shouldn’t be done unilaterally, 2) intervention works best when supported by economic fundamentals that are changing in a direction that supports the currency value adjustment being sought, and 3) it’s helpful for intervention to be coordinated with initiatives in monetary policy and fiscal policy that complement the desired currency movement. None of these requirements fit present circumstances.

Copyright 2019, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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