Lighten Up, Francis
by Dr. Scott Brown, Chief Economist, Raymond James
November 15 – November 19, 2010
To hear tell it, government spending is “out of control,” the Fed is pursuing “reckless” policies that will fuel hyperinflation, and the dollar is “worthless.” Get a grip, people.
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The exchange rate of the dollar is a price, which is determined by supply and demand. The foreign exchange market is huge. The Bank for International Settlements estimates average daily turnover of about $4 trillion (including foreign exchange swaps, spot transactions, outright forwards, etc.), but what matters for the exchange rate is net transactions. The U.S. has a net current account deficit (which is mostly the trade deficit) and a net capital surplus. These two will balance naturally and the dollar is the equilibrating factor. That is, if the net capital surplus is less than the net current account deficit, the dollar will fall, reducing the current account deficit. The current account deficit hit 6.5% of GDP in 4Q05, fell sharply in the recession (to 2.4% of GDP in 2Q09) and is widening again (3.4% of GDP in 2Q10). Recent data suggest that the trade deficit may be stabilizing.
Note that the long-term trend in the dollar is moderately lower, with the exception of two periods (the early 1980s and around the turn of the century) where the dollar rallied then reversed. Both of these dollar spikes were associated with a widening trade deficit. Did people freak out when the dollar slid in the late 1980s or in the last decade? Some probably did – but the outcry wasn’t near as deafening as it is now. Go figure.
There are a number of forces at work on the dollar. The current account deficit has long-term implications (somewhat negative). In the intermediate term, growth differentials appear to matter. The U.S. economy is likely to outperform Europe over the next two to four years. So, the dollar should hold up well against the euro and the pound. On the other hand, emerging economies should grow more rapidly than the U.S., putting downward pressure on the dollar relative to East Asia – and the Chinese currency, in particular. Canada is seen as “a commodity country.” Higher commodity prices imply a stronger Canadian dollar, but Canada also exports a lot of manufactured goods to the U.S. All else equal, a stronger Canadian dollar will dampen exports to the U.S., slowing the Canadian economy and, in turn, weakening the currency. So, we can expect some volatility in the loonie as it searches for an equilibrium. Short term, central bank policies matter. All else equal, easier Fed policy implies a somewhat softer dollar and somewhat higher commodity prices in the near term.
Interestingly, some of the same people that complain about the dollar also complain about the trade deficit. Please, pick one. A softer dollar would be a key element in reducing the trade deficit. A strong dollar would imply a wider deficit.
The Fed’s decision to embark on another round of asset purchases has been widely criticized, with concerns raised by foreign finance officials, Sarah Palin, and even among senior Fed officials themselves. There are two sorts of criticism. One is basically ignorance. Certainly, there are risks and uncertainties associated with quantitative easing, but a lot of criticism is coming from people who know nothing about monetary policy. Quantitative easing is simply expansionary monetary policy. The other criticism is the one that happens whenever the Fed eases monetary policy (that is, the implications for future inflation) – that is a valid debate. Many fear the rise in commodity prices (which are rising in all currencies, not just the dollar). It takes a huge increase in commodity prices to have much of an impact by the time you get to the consumer. The exception is the price of oil, which has a much more immediate impact on gasoline prices (but as we’ve seen over the last decade, higher gasoline prices tend more to dampen economic growth, not fuel the underlying inflation trend). Labor is the more significant cost for most businesses. Wage pressures are low and productivity growth is strong, reducing labor costs per unit output. Do people expect higher inflation from QE2? Well, that’s the point. Inflation expectations drifted lower into the summer, until the Fed began discussing more quantitative easing. Those expectations are back to where they were in the spring – they are not suggesting that the Fed has lost the handle on inflation.
Many supporters of deficit reduction also want to extend the Bush tax cuts. Pick one. There are good economic arguments for temporarily extending the tax cuts, but a permanent reduction would have serious implications for the deficit.
The increase in the deficit over the last couple of years is due largely to the recession and efforts to minimize the impact of the economic downturn. Quantitative easing isn’t some hair-brained scheme, but is simply another form of monetary policy accommodation. The dollar is down, but not out of line with its longer-term trend. Stop the hysterics, please.
