JOHN MASON: The long road back to normal for the US Dollar
BY: John Mason
Earlier this week I wrote about the major impact that the changing value of the US dollar has on emerging market countries, especially in regards to the current situation in Argentina.
Greg Ip writes in the Wall Street Journal about “Dollar’s Dominance Creates Ripples Globally.”
“Though the U.S. share of global output and trade has declined over the decades, the dollar has become even more dominant in global trade and finance. Dollarization means an appreciating dollar may hurt other economies by raising their import and debt costs.”
Mr. Ip goes on to make the point that, “... the dollar isn’t like other currencies. It has become the default choice for trade.”
For example, the dollar’s share of cross-borrowing climbed to 62 percent in 2016 from 45 percent in 2008, at the expense of the Euro.
Thus, when the value of the U. S. dollar moves in international markets, countries and companies…feel it.
Not only does a country’s balance of trade feel the change and economic growth feels the pain, but interest charges also rise, putting pressure on debt loads.
This is a situation in which even the Federal Reserve takes notice.
For example, Jerome Powell, Chairman of the Board of Governors of the Federal Reserve System, made note in a speech that, “rising interest rates should ‘prove manageable’ for emerging markets given they haven’t been surprised and have much better fiscal and monetary policies than in the 1980s and 1990s.”
Yet Argentina has a rate of inflation of 25 percent. It may be the outlier among the emerging market countries these days, yet they still have their own problems.
What this does point to, I think, is that the dominance of the US dollar points to the out-of-equilibrium position the world currently finds itself in.
Perhaps the most noticeable out-of-equilibrium situation in the world right now is the relationship that exists between the direction that the Federal Reserve is moving in and the position of the European Central Bank.
The Federal Reserve System is moving to raise its policy rate of interest and is also reducing the size of its securities portfolio.
The European Central Bank is almost ready to stop buying securities and to start adjusting its policy rates of interest, but, it is not there right yet. The reason is that economic growth in the eurozone has slowed and the ECB doesn’t feel that it can move in a different direction with the uncertainty of where growth rates are going.
And, the Bank of England seems to be in-between directions, somewhat wishy-washy in its current stance.
The Bank of Japan looks like it is going to need some kind of help from Federal Reserve policy, but what that help is, is uncertain at the present moment.
The Bank of China although it has been active in attempting to manage the value of the renminbi, concerns have been expressed about Chinese debt levels and what the central bank needs to do about them.
Given all these different directions, the Federal Reserve looks like the calm, steady force in the marketplace, and the one that will have a major impact on all others. Here we come back to the dominance of the U, S, dollar.
The officials of the Federal Reserve have claimed as their goal, a return to “normalcy,” whatever that might be.
Let’s try and state “normalcy” using two variables, the Fed’s balance sheet and the yield on the 10-year U. S Treasury note.
Most people would argue that the Fed’s balance sheet is far from “normal” right now because of the amount of securities it owns. On May 2, 2018, the Fed held $4.145 billion in securities in its portfolio. On November 1, 2007, just before the Great Recession, the total size of the portfolio was $780 billion.
Now while almost everyone I know says that “normal” is not back to $780 billion, what might the “new” normal be? $2,000 billion? $2,300 billion? Whatever the “new” normal might be, the hope is for a substantial reduction from where the size of the portfolio stands today.
As far as the yield on the 10-year Treasury, analysts often argue that the “nominal” yield is composed of two components, a component referred to as the expected “real” rate of interest, which is often equated to the expected growth rate of the real economy, and the expected rate of inflation,
During the current economic recovery in the United States, the compound, annual real rate of growth has been 2.2 percent. Therefore, assume that the expected “real” rate of interest is 2.2 percent.
The expected rate of inflation that is currently built into the current ten-year yield is about 2.0 percent.
If we add these two together, we come up with an estimate for what the “normal” nominal rate of interest on a ten-yield U. S. Treasury note should be: 4.2 percent. Currently, the yield on the ten-year U. S. Treasury note is about 3.0 percent, which is substantially lower than our estimate.
In other words, the Federal Reserve System has a long way to go to return these two factors to a more “normal” level.
How might this more normal level impact the value of the United States dollar? Might the value of the dollar return to a level closer to what it was soon after the Trump election in early 2017?
If the liquidity in world financial markets decline substantially because of the Federal Reserve shrinking its balance sheet, and if short-term and longer-term interest rates rise to the level just estimated, and if the value of the dollar returns to early 2017 levels, world financial markets would be in for quite a shock!
What would other central banks be able to do given the world dominance of the U. S. dollar?
The world seems to be substantially out-of-equilibrium now and this move by the Federal Reserve System, to achieve more “normality," might just create a world in the throws of a much greater disequilibrium.