Last week, the US Federal Reserve met to consider its monetary policy setting. No action was expected on the federal funds rate that remained at 0.0-0.25%. The interest was in the use of language that would presage the timing and path of future interest rate decisions by the Fed. In the end, two phrases, “exceptionally low” rates to be maintained for an “extended period”, were repeated. However, the Fed added that this would be the case as long as resource utilization, inflation rates and expected inflation remained weak. Future policy direction was made contingent on these three macroeconomic factors.
Resource utilization could mean both industrial capacity utilization and labour utilization. The inverse of the latter is the unemployment rate. In an economy that has become more service-oriented, industrial capacity utilization as a barometer of resource utilization is less important than before. What matters is the unemployment rate. The answer came on Friday. The US labour market report for October showed an economy that was simply not in a position to generate jobs in the near future, even if the rate of job losses slowed. Companies are squeezing costs by cutting hours worked. That is why job losses have slowed. But those who have lost jobs are being shut out of the labour market almost permanently. The number of those who are out of jobs for more than six months is nearing six million.
If one includes those who have been discouraged into ceasing to look for a job and those who had been working part-time involuntarily, the total of unemployed and underemployed is 17.5% of the labour force. These are staggering numbers. So, investors have their answer as to what they should expect from the Fed. Exceptionally low rates would continue for an extended period.
This means more money flowing into developing countries and pressure for currency appreciation. What should they do or what would they do? The answer to the first question is for policymakers and the answer for the second question should be of interest to investors.
So far, currency appreciation in Asia has been muted, if at all. Clearly, if their economic recovery and inflation prospects are more immediate than those of other nations at the centre of the crisis, they should raise interest rates. But a higher interest rate, together with open capital accounts, exerts pressure on currencies to appreciate. Asian governments remain reluctant on that score. One option is to close the capital account and raise interest rates. Not all countries are sure that the capital account tap is theirs for them to turn it off and on at will. For instance, India cannot afford to do that. At least, not yet.
So, the answer is that they simply let their currencies take the pressure. If they do not do it, protectionism lurks around the corner. That is what a new working paper (“The Slide to Protectionism in the Great Depression: Who Succumbed and Why”, NBER Working Paper 15142, July) by Barry Eichengreen and Douglas Irwin states, in a way. It concludes that countries which remained on the gold standard were unable to use monetary policy effectively to combat depression. Hence, they had to resort to trade protectionism to protect their balance of payments.
We can compare this to the current situation, but with a slight twist. Countries that are on the dollar standard are doing better than countries that are not. The dollar is not gold (don’t we know that, and how!). Hence, it is depreciating. Therefore, countries on the dollar standard—unlike those on the gold standard in the inter-war period—are benefiting as their currencies weaken along with the dollar. Countries that are not on the dollar standard are seeing their exports lose competitiveness. Well, up to a point.
Commodity-exporting countries that have allowed their nominal exchange rates to appreciate are not exactly seeing exports perform poorly. Despite the Chinese yuan being pegged to the dollar for the last one year, China’s demand for resources has supported exports from Brazil to South Africa to Australia. So, the time-tested rule that income effects matter more for exports than price effects has held up.
What about countries that do not have this luxury of exporting commodities to China and yet have seen their currencies appreciate against the dollar (and the Chinese currency)? That would be mainly the euro and the yen. It is true that the euro price of renminbi is at a one-year low. Hence, the risk that the euro zone and, perhaps, Japan eventually may resort to trade protectionism if their currencies continue to lose competitiveness should be rising.
Therefore, it appears likely that Asian governments would let their currencies appreciate reluctantly or willingly since protectionism would hurt them more than others. Therefore, betting on Asian currency appreciation against the two Anglo-Saxon currencies appears a low-risk bet, even if investors have to wait longer than they have to with other countries.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org