Weekly: Currency War and Monetary Easing
- Zero rates and quantitative easing have not managed to create sustained inflation in G3 so far
- Declining potential growth and gains from technology have driven structural disinflation
- Monetary policy’s role, in this context, is small
- The notion that growth can be boosted through competitive devaluation is outdated, in our view
Without actually cutting interest rates, the US Federal Reserve has generated major easing of financial conditions this year. While this week’s FOMC statement and accompanying forecasts suggest continued shift toward easing monetary policy in the coming months, we remain unsure if so much dovishness Is justified. The dovish shift may be sufficient to please the markets, but it should be clear that the shift in stance was not seismic. The US central bank officials have demonstrated eagerness to ease financial market conditions from the beginning of this year. Judging by the National Financial Conditions Index calculated by the Chicago Fed, they have achieved that already (although it is also clear that conditions were not particularly tight even during the stock market selloff in December).
The objective of the White House however is clear; it wants the Fed to cut rates to support growth through a weaker dollar. While criticising other economies for currency manipulation, by calling for Fed policy easing repeatedly, President Trump has put the US at the centre of currency wars.
The motivation for this may come from the fact that US real effective exchange rate has appreciated steadily in recent years. Whether measured by using the consumer price (CPI) index or unit labour costs (ULC), the dollar has appreciated, in real terms, by 15-25% over the last five years, as per IMF data.
But shouldn’t the exchange rate have appreciated against major partners given the US economy’s strong growth outturn in recent years? Indeed, looking at growth, investment, and financial conditions index, it doesn’t appear the gradual appreciation of the dollar has had a negative impact on the US.
Furthermore, with trillions of dollars of European and Japanese debt yielding negative interest rates, growing amount of USD-denominated debt issued by both developed and developing economies, demand for USD is unlikely to wane anytime soon, regardless of the Fed’s stance, in our view.
Additionally, there could be a notion that a weaker USD should reduce deflation risk, but this is valid only in theory. Dollar’s fluctuation has had little impact on inflation or inflation expectations in recent years, with disinflation being driven far more by the lack of market power among producers and technology-led cost savings.
Moreover, the highly defensive rhetoric on inflation being well below the Fed’s target needs to be seen in context. Analysis done by the Dallas Federal Reserve shows that core inflation has been on an uptrend since 2013, interspersed with temporary downshifts. In fact, a comparison of trimmed mean and core Personal Consumer Expenditure (which excludes food and energy) inflation shows that core PCE tends to deviate far more than the underlying rate of inflation. We are sure that Fed officials will keep this in mind as they consider forthcoming data. This means that although the next cut is likely to be defended as an insurance against below-target inflation, that evidence is nowhere close to being compelling to support such a move.
If inflation is not particularly low and exchange rate depreciation is not a major source of competitive gains or adequate insurance against disinflation, the desire to see a weaker dollar seems old fashioned and unlikely to provide much dividend, in our view. But implicit in monetary easing by the BoJ and ECB in recent decades has also been a desire to guide respective currencies weaker. Now with the US joining the fray, the markets will be pulled between major central banks of the world, all pursuing dovish policies. The net impact may well be status quo, unless there is major relative change in real interest rates in the US vis-à-vis Europe or Japan. Since this would require an unlikely mix of easing by the US with no commensurate easing by its partners, we don’t see a major dollar easing cycle ahead.
Finally, In the absence of supply-demand imbalance, and in the presence of declining potential growth and gains from technological advancement in advanced economies, a bout of currency weakness is unlikely to turn inflation around. The notion that growth can be boosted through competitive devaluation is therefore outdated, in our view.
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