US official comments on the FX market appear to have increased in frequency.
They are mostly warnings about a strong dollar, but not all comments are dollar-negative.
Policy is the ultimate driver but comments pose headline risk.
Although in office less than a fortnight, the new US Administration is showing a disregard not only for the domestic convention but international agreements like on refugees and its talk about the dollar. Some observers had argued that the conduct of monetary policy was tantamount to currency manipulation, but the G7 and G20 offered a more nuanced understanding.
Manipulation itself was not frowned upon because it violated the sanctity of the markets as some moralists want to argue. Rather manipulating domestic interest rates was accepted. It is not a zero sum game. Currency manipulation to boost exports is a zero sum undertaking and is thought best to avoid.
Over the last couple of weeks, several Administration officials have talked about the dollar. Some of these remarks were in the confirmation hearings and needed to be kept in that context. However, others seem to have gone out of their way to comment. Trump himself warned a few days before the inauguration about too strong of a dollar.
Today, the head of Trump’s new National Trade Council, Peter Navarro, told the Financial Times that the euro was “grossly undervalued.” He warned that euro was like an “implicit German mark” and its low valuation gave German an advantage over its trading partners. Navarro said Germany was one of the main obstacles to a trade deal with the EU. He confirmed what has been suspected: TTIP, the Transatlantic Trade and Investment Partnership negotiations, will not be going forward under Trump.
On balance, many of the comments from Trump officials have expressed concern about the strength of the dollar or, as Navarro, complained about other currencies being undervalued. The OECD confirms. Its models see the euro at nearly 25% undervalued, sterling almost 16.5% undervalued and the yen 11% under-valued. The Mexican peso, whose marked depreciation has been exacerbated by comments by Trump, is undervalued, according to the OECD, by 147%.
On the other hand, Ted Malloch, who is widely tipped to be the next US ambassador to the EU(and presently a professor at Henley Business School at the University of Reading) is a Eurosceptic. He said he wanted to short the euro and intimated that the eurozone could collapse in the next 18 months.
It is still the early days of the Trump Administration, and it is not clear whose opinion will carry the day. Trump, for example, seemed to support torture to acquire information but deferred to the Secretary of Defense General Mattis. It is not known whether the comments are one-off or part of a sustained campaign.
At the same time, we argue that reason the dollar is strong is not that European, Japanese, and Mexican officials want a weak currency, though some officials clearly do. Rather the dollar’s strength is not built on wishes but the incentive structure created by actual policy. In particular, the divergence of monetary policy, broadly understood, has been, arguably, the single biggest force lifting the US dollar.
There is some anticipation of a more supportive policy mix. Fiscal policy has been neutral to a drag in recent years, but it has been clear since last summer that regardless of the election outcome US fiscal policy would be more accommodative. That policy mix of looser fiscal and tighter monetary policy is associated with currency appreciation. Looser fiscal policy includes tax cuts (reform), infrastructure spending, and some supply-side deregulation. Alone, such fiscal efforts would also likely be understood by investors as favorable for the dollar.
Looser fiscal and tighter monetary policy was the policy mix under Reagan-Volcker that led to a dramatic dollar overshoot in the early 1980s and was the first dollar rally since the breakdown of Bretton Woods in 1971. It was also the policy mix in Germany when the Berlin Wall fell. The fiscal laxity needed to finance the leveraged buyout of East Germany was offset by the tightening of monetary policy by the Bundesbank. The Deutschemark overshoot that resulted spurred an ERM crisis that ultimately paved the way for monetary union.
Another consideration has joined the mix. The border tax adjustment is seen by many as automatically spurring a significant dollar appreciation. It is part of a destination-based corporate tax that is being touted. It would tax imports and exempt exports. Relying on theory, many economists expect that the dollar would rise to offset the tax. A 20% tax would produce a 25% appreciation of the dollar.
The view is based on economic identities that are true by definition. If the dollar does not appreciate in full, then the domestic savings must increase and/or domestic investment must fall, with the rest of the world moving equally but in the opposite direction. We are skeptical that a change in goods prices will automatically drive the dollar. In our understanding of foreign exchange drivers, we put an emphasis on the market for capital not the market for goods.
We can understand how a tax on imports can boost the price of goods that could, in turn, increase the general price level (inflation). Yet, higher import prices could also sap the purchasing power of US households and weaken aggregate demand. We can envision how a tax on imports and exemption for exports can boost some sectors’ profitability and boost corporate savings.
Jawboning can impact foreign exchange prices, as we have seen today, with the pop in the euro following Navarro’s comments. However, over time, we expect policy is the ultimate driver of exchange rates. Although details about the new Administration’s fiscal policy are not known, we anticipate a bullish mix and other policies that are broadly supportive of the dollar. The jawboning will likely soon reach a point of diminishing returns as has the jousting with Mexico, and as Japanese officials have also discovered.
It is possible that to offset the strong dollar policies that President Trump could order an intervention in the foreign exchange market. Since 2008-2009, many observers, media, and some policymakers have argued that the US (and others) are engaged in currency wars. We demurred. If the US were to intervene to drive the dollar lower, it would make a mockery of the earlier cries.
Policymakers did not recall the lesson of the Great Depression and weakened the financial pipes before the financial crisis. Policymakers did not recall the lessons of the 1920s about the disparity of income and wealth and the political blowback that could result. Policymakers did not recall the limits of a country’s willingness and ability to service foreign debt from current production. Policymakers may be forgetting the disastrous consequences of protectionism (taxing imports and exempting exports) and beggar-thy-neighbor currency policies.
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