It has become almost a mantra for the media. Every news article on currencies contains a seemingly obligatory phrase associating strength in the US dollar, either past or prospective, with the Fed’s long-awaited normalisation of short-term interest rates. If you hear it enough times, like political banter, you are supposed to believe it. Resist that intuitive leap of faith and rely on analytical thinking. A more plausible thesis is that US Treasuries and dollar-denominated assets in general have been perceived as safe havens in a global economy that is flirting with deflation. Similarly, the booms and busts of emerging currencies have more to do with China’s gluttonous demand for commodities and the US dollar’s role in funding for commodity currency trades than Fed policy. Zero interest rates and QE policies of western central banks have been classic breeding grounds for disruptive and potentially destabilising carry trades. The Fed should weigh these undesirable costs of unconventional monetary policies, including distortions to asset prices and increased use of cheap leverage, against their diminishing benefits in stimulating economic activity. Absent some compelling evidence to the contrary, the Fed should be thinking in terms of removing the proverbial punch bowl before the party gets out of hand.
Consensus Thinking on US Dollar’s Strength
On a trade-weighted basis, the US dollar has risen about 8% this year and almost 11% over the past 12 months. That move is significant. Even though the Fed’s dual mandate focuses on full employment and price stability, the Fed does and should care about large changes in the terms of trade. One often-cited concern is that lower import prices will make it more difficult for the Fed to reach its inflation target of 2%. Here is the empirical evidence. A 10% rise in the trade-weighted dollar lowers overall inflation about 3/4% spread over three years, or about 0.25% per year.1 That may not seem like much, but every little bit matters to central banks that believe deflation would be more destabilising than a bit more inflation. Underlying that calculation is the presumption that the currency remains elevated. Unfortunately, one of the main reasons multiyear currency forecasts are notoriously inaccurate is because circumstances do change.