The Contrary Dollar

A euro-dollar exchange rate around current levels is what we should want, since developments that could cause the currency to move away from current levels are undesirable. A column by Barry Eichengreen.

Barry Eichengreen
«Exchange rates move with growth rates.»

The weak U.S. dollar has been one of the financial surprises of 2017. I will admit to having been wrong footed. I thought that the policy promises of President Trump and the new Congress all pointed in the direction of a stronger dollar. That the United States had been one of the bright spots in a generally lackluster global economic landscape pointed in the direction of a stronger dollar. That the Fed was embarked on normalizing the level of interest rates and had signaled readiness to start shrinking its balance sheet similarly pointed in the direction of a stronger dollar.

Well, it hasn’t turned out that way. The dollar is down nearly 10 per cent on a trade-weighted basis since the beginning of the year. This makes it important to mark our beliefs to market, as a first step in figuring out where we go from here.

The obvious point is that Trump and the Congress haven’t delivered on their promises. There have been no corporation and personal tax cuts and no $1 trillion infrastructure initiative to goose demand and drive up the dollar. There has been no across-the-board tariff or border-adjustment tax to restrict imports and drive up the dollar. Many people questioned the capacity of a Trump Administration to effectively execute its economic program. But few anticipated this level of incompetence.

Prospects for growth have turned

Even more surprising is how the prospects for growth have turned. The euro area is no longer underperforming the United States on the growth front. In the first quarter of 2017 it recorded an annualized growth rate of 2.0 per cent, compared to just 1.6 per cent for the U.S. The Eurozone economy then accelerated further in the second quarter, by an annualized 2.4 per cent, according to recently-released Eurostat figures, a pace just matched by the United States.  U.S. employment numbers look impressive, with the most recent Employment Report showing the addition of 209,000 jobs in July. But many of those are low-wage, low-productivity jobs in restaurants and related sectors, which provide only a modest boost to aggregate economic growth.

Financial markets had grown accustomed to thinking about Europe as a sick economy, so all this comes as a jolt. A decade of structural reform is paying off, as evident in the growth of Spanish and Portuguese exports. Political uncertainty has been resolved with the defeat of Geert Wilders in the Netherlands and the victory of Emmanuel Macron in France. Existential fears about the survival of the euro and the European Union have receded with a new agreement between Greece and its creditors and hopes that Macron and Angela Merkel might successfully reboot the European project.

Exchange rates move with growth rates. With Eurozone growth being stronger than expected, absolutely and relative to growth in the United States, the euro is stronger than expected, the dollar weaker. The link between exchange rates and growth rates is, of course, yields. Stronger Eurozone growth creates expectations of higher euro interest rates going forward, while weaker U.S. growth creates suspicions that the Fed will remain on hold.

Reverting to the random-walk approach

And that points to the final surprise: those who expected the Fed to continue raising rates and rapidly shrink its balance sheet have been disappointed. Wage inflation continues to disappoint. Most recently it ran at a disappointing 2.5 per cent in July. Wage growth of 3 to 3.5 per cent would be more in line with the Fed’s 2 per cent inflation target, given that labor productivity has been growing at an average annual rate of slightly more than 1 per cent. In addition, political pressure on the Fed has diminished, what with President Trump recently reminding the Wall Street Journal that his personal preference is low interest rates.

So where is the dollar headed now? The random-walk approach to forecasting suggests that the best forecast of the future exchange rate is the current exchange rate. Having been chastened by the inaccuracy of my earlier forecast, I am inclined to revert to the random-walk hypothesis now.

Moreover, I would argue that a euro-dollar exchange rate around current levels is what we should want, since developments that could plausibly cause the currency to move away from current levels are undesirable, or worse. One such development would be a sharp slowdown in European growth. Mr. Macron could fail to push through his labor-market reforms. Hopes for rapprochement between Macron and Merkel could be disappointed. The Five-Star Movement could make greater than expected gains in the Italian election. There could be another surge of refugees and new problems with Russia. Brexit negotiations could falter, or the EU could go to diplomatic war with Poland. The result would be a significantly weaker euro and stronger dollar, but this is not something we should want.

Many things we should not want

Or the dollar could strengthen because Trump and the Congress finally agree to massive unfunded tax cuts. Demand stimulus in a near-full employment economy will not elicit much in the way of additional domestic supply. So demand will have to be shifted toward cheaper, foreign-sourced goods, something that would be accomplished by appreciation of the dollar. Trump may yet resort to import restrictions, on steel and aluminum for example. Steel- and aluminum-using firms will then look to domestic sources of supply. But in a near-full-employment economy, that additional supply will not be forthcoming. Firms will, instead, have to source those same supplies abroad, which they will do if higher tariffs are offset by a stronger dollar.

But, again, this is not something we should want. Unfunded tax cuts will give the U.S. economy a sugar high but at the cost of serious damage to the medium-term financial outlook. Import restrictions that threaten the global trading system will do U.S. business more damage than good.

Finally, there is the risk of further escalation of the conflict with North Korea. Trump’s off-the-cuff approach to diplomacy may have tarnished the safe-haven status of the dollar. But it remains the case that in a diplomatic and military crisis there is nothing investors value more than liquidity. And the market in U.S. treasuries remains the single largest and most liquid market in the world. Conflict with North Korea would be dollar positive, but again this is not something we should want.

More of the same is the best scenario

Then there are scenarios in which the dollar, rather than recovering, weakens still further. Imagine that the Congress fails to raise the debt ceiling in September. Conservative Republicans insist that they will do so only if the higher ceiling is accompanied by additional spending cuts. And there is scant chance that there will be agreement on what to cut in what remains a few weeks. The Treasury has already all but exhausted the emergency measures available to it under such circumstances. A government shutdown and an interruption to federal debt service payments would not be dollar positive, to put it mildly.

Then there is the possibility of further revelations about Russian meddling in the U.S. election and complicity by individuals now high up in the Trump Administration. Impeachment, whatever else one has to say for it, would create high uncertainty. The dollar did poorly during Watergate and Iran-Contra. It and the U.S. economy would similarly suffer if there are serious new Trump-Putin-related revelations.

So the best-case scenario for the dollar is more of the same.  The alternatives are too dire to contemplate.