So far 2018 has seen an acceleration of a trend we saw last year which is a fall in the value of the US Dollar. The latest push was provided by the US Treasury Secretary only yesterday at Davos. From Bloomberg.
“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin told reporters in Davos. The currency’s short term value is “not a concern of ours at all,” he said.
“Longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and will continue to be the primary currency in terms of the reserve currency,” he said.
The way it then fell it is probably for best its value is not a concern as the rhetoric was both plain and transparent.
A day before Trump’s scheduled arrival in the Swiss ski resort of Davos for the World Economic Forum’s annual meeting, Treasury Secretary Steven Mnuchin endorsed the dollar’s decline as a benefit to the American economy and Commerce Secretary Wilbur Ross said the U.S. would fight harder to protect its exporters.
The response to the words is a pretty eloquent explanation of why policy makers have a general rule that you do not comment on the level of the exchange rate. Not only might you get something you do not want there is also the issue of being careful what you wish for! Sadly the Rolling Stones were not on the case here.
You can’t always get what you want
But if you try sometime
You get what you need
However you spin it we are in a phase where the US government is encouraging a weaker dollar as part of the America First strategy. It has already produced an echo of the autumn of 2010 if this from the Managing Director of the IMF is any guide.
“It’s not time to have any kind of currency war,” Lagarde said in an interview with Bloomberg Television.
Criticising someone for rhetoric by upping the rhetoric may not be too bright. Also there are more than a few examples of countries trying to win the race to the bottom around the world.
What does a lower US Dollar do?
Back in November 2015 Stanley Fischer gave us the thoughts of the US Federal Reserve.
To gauge the quantitative effects on exports, the thick blue line in figure 2 shows the response of U.S. real exports to a 10 percent dollar appreciation that is derived from a large econometric model of U.S. trade maintained by the Federal Reserve Board staff. Real exports fall about 3 percent after a year and more than 7 percent after three years.The gradual response of exports reflects that it takes some time for households and firms in foreign countries to substitute away from the now more expensive U.S.-made goods.
Also imports are affected.
The low exchange rate pass-through helps account for the more modest estimated response of U.S. real imports to a 10 percent exchange rate appreciation shown by the thin red line in figure 2, which indicates that real imports rise only about 3-3/4 percent after three years.
This means that the overall economy is affected as shown below.
The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years. Moreover, the effects materialize quite gradually, with over half of the adverse effects on GDP occurring at a horizon of more than a year.
Okay we need to flip all of that around of course because we are discussing a lower US Dollar this time around. Net exports will be boosted which will raise economic output or GDP over time.
If we look at the US Dollar Index we see at 89.1 it has already fallen by more than 3% this year. The recent peak was at just over 103 as 2016 ended so we have seen a fall of a bit under 14%. The official US Federal Reserve effective exchange rate has fallen from 128.9 in late December 2016 to 116.8 at the beginning of this week so 116 now say. Conveniently that gives us a fall of the order of 10%.
So if we look up to the preceding analysis we see that via higher exports and reduced imports US GDP will be 1.5% higher in three years time than otherwise.
What about inflation?
There is a lower impact on the US because of the role of the dollar as the reserve currency and in particular as the currency used for pricing the majority of commodities.
While the Board staff uses a range of models to gauge the effect of shocks, the model employed in figure 4–as well as other models used by staff–suggests that the dollar’s large appreciation will probably depress core PCE inflation between 1/4 and 1/2 percentage point this year through this import price channel.
You may note that Stanley Fischer continues the central banking obsession with core inflation measures when major effects will come from food and energy. It would be entertaining when they sit down to luncheon to say that we are having a core day so there isn’t any! Have you ever tried eating an i-pad?
So inflation may be around 0.5% higher.
What about everybody else?
The essential problem with reducing the value of your currency to boost your economy via exports is that overall it is a zero-sum game. As you win somebody else loses. So the gains are taken from somebody else as no doubt minds in Beijing, Tokyo and Frankfurt are thinking right now. Of course pinning an actual accusation on the United States is not easy because of its persistent trade deficits.
Furthermore the exchange-rate appreciation seen elsewhere will not be welcomed by the ECB ( European Central Bank) and particularly the Bank of Japan. The latter is pursuing an explicit Yen depreciation policy to try to generate some inflation whereas what it has instead seen is a rise towards 109 versus the US Dollar. Of course workers and consumers will have reason to thank the lower dollar as lower inflation will boost their spending power.
Later today we will see how Mario Draghi handles this at the ECB policy meeting press conference. He finds himself pursuing negative interest-rates and still substantial if tapering QE and a stronger currency. It is hard for him to be too critical of the US though when even Christine Lagarde is saying this.
LAGARDE: GERMANY’S 8% CURRENT ACCOUNT SURPLUS IS EXCESSIVE ( @lemasabacthani)
Of course that takes us back to a past competitive depreciation which Germany arranged via its membership of the Euro.
There is a fair bit to consider here. As it stands it looks as though the US economy will benefit over the next 3 years (convenient for the political timetable) by around 1.5% of GDP at the cost of higher inflation of 0.5%. There are two main problems with this type of analysis of which the first is simply the gap between theory and reality. The smooth mathematical curves of econometrics are replaced in practice by businesses and consumers ignoring moves for as long as they can and then responding but by how much and when? So we see a succession of jump moves. The other issue is that exchange-rates are usually on the move and can change in an instant unlike economies leaving us wondering which exchange-rate they are responding too?
Next we have the awkward issue of a country raising interest-rates and seeing a currency depreciation. Theory predicts the reverse. I have a couple of thoughts on this and the first is about timing. In my opinion exchange-rates these days move on expectations of an event so they have already happened before it does. So the current phase of interest-rate rises was reflected in the US Dollar rise from the summer of 2014 to the spring of 2015. That works because if anything we have seen fewer rate rises than expected back then and the bond market has fallen less. As to the Federal Reserve well with the US Dollar here and inflation with a little upwards pressure it will therefore find a scenario which makes it easy for it to keep nudging interest-rates higher.
Meanwhile there are other factors which are hard to quantify but seem to happen. For example a lower dollar coming with higher commodity prices. Hard to explain and of course there are other factors in play, But it seems to have happened again.
Me on Core Finance TV