America First, Dollar Second and the Reactionary Federal Reserve

Paul Volcker, former Chairman of the Federal Reserve System, previously wrote that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports and even the level of economic activity.” Given Volcker’s analysis, the US may have cause for concern.

Forces such as rising yields on international currencies such as the Yen and the Euro and corresponding global macroeconomic growth drove investors away from the dollar in 2017. The U.S. Dollar Index, a measure of the dollar’s relative strength against the values of the currencies of several of our major trading partners, fell almost 12 percent over the last year. Considering the US dollar is the world’s most traded currency and accounts for almost 64 percent of all foreign currency reserves, a 12 percent decline is enormous.

Yet, all of this seems a bit counterintuitive. Ostensibly, there was nothing wrong with the United States economy in 2017. The recent passage of the Tax Cuts and Jobs Act, corporate earnings growth and low unemployment numbers helped the S&P 500 to a robust 24 percent gain since the time of President Trump’s inauguration last January. This represents the best annualized domestic growth realized since markets rebounded from the Great Recession in 2009. Even so, the dollar lost ground to superior growth abroad.

A number of factors, including the trade benefits from the weaker dollar and a long overdue global economic rebound from the previous recession in 2009, propelled Chinese, Korean, Indian and a number of emerging markets indices to returns greater than those seen domestically. For example, with Eurozone unemployment falling over one percentage point during 2017 to 8.7 percent, forex yields proved far more attractive overseas than at home, causing many institutions to shed portions of their dollar holdings.

A number of factors in the coming year provide evidence that the dollar rout is not over yet. The aforementioned global growth has shifted the thinking of many foreign central banks. In the European Union, the monetary policy debate has changed from ‘if” to “when” the European Central Bank should end its quantitative easing program originally designed to restart economic growth and boost asset prices after the Great Recession.

In Asia, the tone is no different. While lagging annual inflation of around 0.8 percent in 2017 has yet to signal any definitive need for a monetary policy shift, the Bank of Japan expects strong exports and quickening GDP growth to push inflation to its long term 2 percent target by early 2020. According to Reuters, Japan is ahead of schedule on eradicating the deflation seen in past years, leading many to believe an end may be near to the negative interest rates set by its central bank.

In sum, there remains ample reason to believe foreign currencies will continue to strengthen against the dollar in 2018. On the back of such data, Citibank projects a further 5 percent decline in the dollar index over the next year. All of this begs the question: what are the consequences?

While it’s true the current exchange rate climate benefits previously siloed sectors of the economy such as manufacturing and materials by effectively giving foreign buyers a discount on American goods, a weak dollar does not come without its costs. Aside from reduced spending power during travel, serious cause for concern comes from the increased prices of goods at home. Total spending on imports in 2016 amounted to a sizeable 12 percent of our $18.6 trillion dollar GDP, with the largest contributions from spending on electronics, computers and petroleum respectively.

Even though typical core inflation measures exclude the prices of more volatile commodities like food goods and petroleum, price increases on these trade items could certainly lead to inflation. Taken alongside a 4.1 percent unemployment rate — the lowest since December of 2000 — and the wage and bonus benefits given to millions of Americans by employers such as Walmart, AT&T and Capital One as a result of the recently passed tax plan, inflationary pressures seem to be rematerializing to levels not seen in recent years.

In macroeconomic terms, these numbers are significant. Current unemployment is below the Federal Reserve’s estimates of the non-accelerating inflation rate of unemployment (or NAIRU), the level at which economists expect inflation to rise. Indeed, with core inflation from last December rising to 1.8 percent according to the Bureau of Labor Statistics, the Fed’s long run target of 2 percent seems well within reach for 2018.

To counteract price pressures from the weak dollar, wage increases from unemployment below the NAIRU, and, more broadly, to maintain price stability, the Fed must look to rapidly raise rates. The aforementioned factors form the basis for the generally accepted argument that the Fed will raise rates in 2018. However, their severity will determine the answers to the more important questions such as “How soon?” and “By how much?”

According to the Federal Reserve’s most recent dot plot, which measures the Board of Governors’ opinion on future interest rates, three rate hikes of 25 basis points each is the most common expectation for 2018. This projection largely factors in what the Fed thinks will be appropriate based on their projections for the strengthening of inflation metrics. However, the consensus at the Fed belies the concerns of a more rapid return of inflation, which given the falling dollar, is entirely likely.

Moreover, the 75 basis point projection does not adequately account for the strength of the business cycle. Now almost 10 years out of the last recession, major financial institutions such as Barclays and Goldman Sachs have begun to include the possibility of a recession in their near term economic forecasts. With current interest rates at just 1.25 percent, the need to raise rates takes on more importance given the propensity to lower them during economic downturns.

Considering the uncertain success of the negative interest rates central banks used to stimulate economic activity in Europe and Japan after the Great Recession, the Fed tends to look to lower rates no further than a nominal 0.25 percent or so, which does not give it much room if it had to undertake a course of sustained easing in the near future. As a point of context, the Fed lowered rates by 5 percentage points during the last recession. Effectively, the low interest rate environment leaves the Fed with its hands tied behind its back, without the ability to further stimulate the economy.

While dovish sentiments would suggest reactionary rather than proactive measures to manage the return of inflation and fewer rate hikes rather than more to avoid the risk of steering the economy toward a recession, it is important to mind the damage untamed inflation could wreak on the economy. With market volatility at historic lows, downplaying the consequences of inflation could prove fatalistic, removing the Fed from control over powder-keg factors that could threaten the peaceful gains seen by equity markets in 2017. Four rate hikes, rather than three, and a prolonged plan for additional increases in 2019 will enable the Fed to maintain price stability and, more importantly, position it better to accommodate the next recession.