Why the dollar is still king
In the last one month, things have begun to turn in the sovereign bond market. The Federal Reserve (Fed) raised the federal funds rate (FF rate) in June to a maximum of 1.25%. Not only that, the minutes of the meeting of the Federal Reserve open market committee (FOMC) have confirmed that the Fed stands ready to start shrinking its balance sheet in the next few months.
Some commentators have called the policy stance of the Fed wrong (see, for example, Martin Sandbu of the Financial Times). They feel that the move to raise the policy rate in baby steps risks an end to the economic expansion that is eight years old. They are making the same mistake that they made before 2008. Even if the inflation rate were below 2.0%, and stayed that way, the FF rate in real terms is negative. Or, even if the inflation rate were to edge down to 1.5%, the real FF rate would be barely positive. Hence, the monetary policy is still very accommodative especially since the unemployment rate is below 5.0%, supply of leveraged loans is at a record high, stock indices are at record high valuations and stock market volatility at record lows.
According to critics, this line of thinking is flawed because it mixes both financial market and real economy objectives. One instrument can work with only one objective. That objective is inflation and that is below the (implicit) target of 2.0%, and hence, interest rates should not be raised. Financial stability should be pursued through macroprudential measures. Unfortunately, this is an old movie and it does not have a happy ending. Textbooks always inform students that interest rate transmission works through financial variables such as long-term interest rates and stock markets. Hence, the argument that the interest rate policy tool should be wielded only to achieve the inflation objective does not wash.
If the Fed had incorporated financial stability into its mandate, it would not have waited this long to begin to normalize monetary policy. Hence, what it is doing is to belatedly acknowledge the financial instability risks by normalizing monetary policy, even though the inflation rate is below 2.0%. The awkwardness of tightening monetary policy when the inflation rate is well behaved would not be necessary if the Fed had not left it too late to do too little, on financial instability risks.
Therefore, the point is that with the Fed having left it too late, the risk of a stock market crash heralding a recession is not trivial. Of course, critics would blame the Fed for having normalized monetary policy a little too enthusiastically, precipitated a stock market crash and brought about an economic recession. In contrast, we would argue that the fault lay in the Fed not normalizing monetary policy on time and with a little more alacrity. If it continued to sit on its haunches, it would risk a bigger crash and a bigger and longer recession.
What would the stock market crash and the prospect of an economic recession do to the US dollar? In spite of the Fed having begun to normalize monetary policy earlier than the European Central Bank (ECB), the Bank of England and the Bank of Japan have, the US dollar has declined. The popular US dollar index, or DXY (it has more than a 60% weight for the euro), has dropped 6.1% since the beginning of the year. The euro, in particular, was at around $1.035 in December of last year. It has since rebounded to $1.14 per euro.
In terms of economic fundamentals, the US dollar ticks many boxes. The US current account deficit is under control. The real interest rate for the US dollar (-0.65%) is higher than it is for the euro (-1.05%). Perhaps Japan has a slightly higher real interest rate (-0.4%). These are based on overnight lending rates minus the most recent inflation rate.
Moving away from these most relevant exchange rate-specific fundamentals, if one looked at economic risk factors such as economic growth rate, the safety and stability of the banking system, America’s fiscal deficit and government debt, the US does far better than the eurozone nations.
Sovereign bond yields in Italy and Spain are lower than that of the US 10-year sovereign yield. That is laughable. It is because the ECB has been supporting the prices of eurozone sovereign bonds. If anything, that alone should be enough to keep the euro permanently undervalued against the US dollar. Eurozone has not yet stopped printing money to shore up the prices of eurozone sovereigns.
Without that support, the cost of sovereign debt in the eurozone would be much higher, exposing the underlying vulnerabilities of their public finances that the ECB has done so well to hide from public scrutiny. Nor is it clear that eurozone banks are safe and sound. So, risk premium considerations too do not make the case for a strong euro against the US dollar.
What else is keeping the euro strong and the US dollar weak? It is the perception fed by incessant or unceasing popular commentary that the current administration risks America’s economic and political isolation with its policies and rhetoric, and that it would lead to less investor interest in American assets and in the American currency.
Put differently, the weakness of the US dollar reflects the fact that the world is now looking to the eurozone and even China to provide global leadership. This is at best a hypothesis and, at worst, wishful thinking. In our view, the weakness of the US dollar is an anomaly. Period.
V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. These are his personal views. Read Anantha’s Mint columns at www.livemint.com/baretalk
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