Currency Wars, the USD and the Fed
As explained in a previous post, in the process of evaluating and communicating the path of the policy rate for the coming 12 months, it must assess risks to growth, jobs, inflation, bubbles, and the future potential cost of a need for fast tightening if it does not tighten now. We discuss the likely scenario in this important post. Read on to be ahead of the curve.
When a central bank embarks on a tightening cycle while others are either neutral or still have a “dovish” bias, the currency tends to appreciate. Below is the nominal effective exchange rate for the USD for the past 15 years (up is general appreciation, down is general depreciation):
The USD appreciated in broad terms starting in 2014, mostly because the Fed announced it was going to stop increasing the purchasing of assets with newly printed money (printing naturally depreciates the currency), which caused a “taper tantrum” because a lot of global funds were invested in other countries and were at risk of losing if the usd appreciated in the carry trade (because those other currencies would depreciate versus the usd). Here is the Fed balance sheet for the past 15 years:
Currently, the only central bank with at least a bit of a “hawkish bias” is the Fed, and this has pumped up the USD to a very high value historically and is making it hard for Trump to create manufacturing and export sector jobs, as promised. Trump is rumoured to also be preparing a massive fiscal program that will reduce taxes and increase infrastructure and defense spending, which I do not want to debate about (for the record, I am against reducing taxes to the rich for the USA).When you have fiscal expansion, you get extra spending and investments, which boosts internal domestic demand and adds inflation pressure, which adds more need to tighten monetary policy, which appreciates the currency. All this does not help exports and does not help to decrease the current account deficit (which is a measure of how much the entire country “borrows” from the rest of the world: negative is net borrower, positive is net lender).
Below is the current account as a % of GDP for the USA since 1980. It was generally positive between 1880 and 1980 (100 years) and has been negative since 1980. Explaining all this and adding the required nuances would be way too long, so please just look at the chart:
Notice that starting in 1985, the current account went from negative to zero around 1990… this was after the passing of the Plaza Accord, where major countries of the world met at the Plaza Hotel (USA) and agreed to depreciate the USD in a gradual and orderly fashion to improve the US current account, and it worked. After 1990, the accord was dropped and everyone did what they wanted and the USA became THE place to send capital following the end of the Communist Era and the process of economic, financial, and cultural globalization.
Currency wars
After 1990, China and Japan embarked on massive interventions to manipulate their currencies to make them weaker so that it would boost exports. This is the famed “export-led growth strategy”, and it worked for a while (it worked for Japan in the 1970s and for China for the 1990s and 2000s). After all, you produce more stuff (goods and services) and create more jobs and income and tax income for the State when you 1) can produce more (not a problem) and 2) have strong demand (may be a problem)… demand can come from inside (people, businesses, and governments that buy stuff made in the country) OR from other countries, which is exports.
Today, all major countries are stuck with negative structural forces: demography, stagnating wages for the masses, and many other complexities. I discuss these issues in my book, but here I want to talk about what countries can realistically do to get some growth in the near term… It comes from C + I + G + NX: consumption of households, private expenditures on real investments (buildings, machinery, housing, etc), public spending, or exports (NX is net exports = exports minus imports). People and governments are stuck with high debt and can’t spend much more, people want to save for retirement as they age, so they don’t spend much, university graduates are stuck with record high debts, so they don’t become heavy spenders after graduation and for a long time afterwards, and businesses are not spending all that much domestically, as production costs are too high… so what is left? … exports! In the short and medium run (1–4 years), you can export more if the currency depreciates. In the long run it is more complicated (and I don’t want to talk about it here)…
I am looking at many indicators for the USA and I DO NOT see any sign of “overheating” at all. Capacity utilization, industrial production, labor market indicators, inflation, trade, various “economic activity” indices, credit growth, etc. They all signal a modest growth outlook. The US economy could get a boost from fiscal expansion, but the issue will eventually become the federal budget balance: you can run up government debt for a while, but at one point, you have to get things under control BEFORE the bond market forces it on you.This brings me to the Fed. The US central bank wants to tame financial speculation and bubbles but does NOT want to hit the brakes too hard on the “real economy” that is cruising at a tepid pace. The issue for the Fed is that they “have to” tighten a bit due to a bit of inflation and due to the Trump (potential) fiscal expansion and I would dare say simply because they feel the need to do “something” other than stand around (which I think they COULD actually do for another full year), but it may all be mostly huff and puff. They will likely raise the policy rate at the next meeting, and that puts a bullish bias on the already-overvalued USD, but I think the tone from the Fed will be quite moderate and the USD is set for a general deflating starting in April, especially once Euro political risk has passed, as I expect it will. The Euro will likely appreciate quite a lot after April.We are back in a world of currency wars. Central bank officials are trying to “talk down” their currencies, which is really a negative sum game when everyone does it, and I personally think central banks should stop this game and accept the free movements of their currencies based on market supply and demand. Canada, Switzerland, and New Zealand all played the game quite a bit. Japan finally stopped recently. But the issue for the USA now is that they lose if they are the only ones NOT playing the currency war game (as is currently the case).What to make of all this? The USD may have a few weeks of bullishness left, but it is set for a long depreciation, unless the Trump fiscal program is really impressive, which would drive the USD even higher and bring the trade war issue even more to the forefront.
The special status of the USD
Although US exports would benefit from a USD depreciation, things are “not that simple” for a superpower with THE most used currency in global markets. The USD is used in oil and most commodity transactions, as well as global interbank markets and other major markets. This makes the USD and USD-denominated assets more demanded than they otherwise would be… this makes US asset prices higher and keeps US interest rates lower than they otherwise would be, thus making it easier for the US government and US multinationals to get capital at low cost, etc. This is a major long term advantage that is brought about by a “strong” currency, and this is why things are a bit more complicated for the USD than for others. Does Trump understand this? Not the details, no. But the global strategists of the CIA and FBI do, and this eventually makes its way to the President.Hence, we will see on what side the pendulum swings, probably starting in April. My 2 cents is that the USD will fall at least 5% after April. The Fed may keep a hawkish tone to tame financial bubbles but not move for the rest of the year to help exports and domestic demand… and markets may catch on to this little game… Liked the insights? Like and share! It’s free!
Pascal Bedard
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Originally published at www.yourpersonaleconomist.com.
