Why a stronger greenback should worry the US
Andrew Sheng says with the unconventional US monetary policy not working and the long-held-off Fed rate rise inevitable, the incoming president will have to make a strategic call
The US Federal Reserve did not raise interest rates on September 21, as Fed chair Janet Yellen decided to wait for further evidence of continued progress towards the objectives of maximum employment and price stability. Some analysts felt any rate increases would be seen as favouring one party in the November US presidential election.
Overall, relieved stock markets rallied somewhat, while currency markets moved sideways. The futures market sees a 60 per cent chance of the Fed raising rates in December, after the election.
The key question is whether the US dollar will strengthen. So far, it has been strong against emerging market currencies, flat against the euro and weakened relative to the yen.
Interest rate behaviour today is determined largely by monetary policy, which is why global markets are particularly nervous about Fed rate adjustments. The US remains the dominant military and economic power and is consequently the safe-haven currency. Whenever geopolitics becomes tense, as now, the flight is always towards the dollar. Furthermore, all signs point towards the US performing best among advanced economies.
However, there is a disconnect between US recovery and trade growth. The US consumption pattern has changed from consuming durables towards spending on services, such as apps and digital entertainment. A partial shift towards manufacturing at home is why exports to the US have not increased much. With global trade growing slower than GDP, emerging markets are not growing due to the traditional cyclical uptick in exports.
The bad news is that, historically, a strong dollar has been associated with slower global growth and vice versa. The explanation is that when the dollar is weak, capital flows out to the emerging markets, stimulating trade and investments. When the dollar is strong, capital flows back in and if the US is unable to recycle these flows, global growth weakens. The power of the US to recycle global capital flows is critical to global recovery. Unconventional US monetary policy, in the form of near-zero interest rates, is not working because the transmission mechanism of cheap money to the real economy is not working. The private sector won’t be confident about the future until there are stronger signs of sustained consumer spending. Furthermore, much-needed public-sector investments in infrastructure are being constrained by the large debt overhang and toxic politics.
In short, global capital flight to the dollar will mean global secular deflation – as zero-interest-rate dollar holdings have the same deflationary role as gold in the 1930s. Holding gold was deflationary because spending stopped as more and more gold hoarding drained liquidity from the market.
But wait a minute. If the Chinese economy is still growing three times faster than the US in GDP terms (6.7 per cent versus 1.8 per cent), shouldn’t the renminbi appreciate? Yes, China is running a current account surplus, but capital outflows are currently running at about the same level as trade surpluses, so foreign exchange reserves are flat. Many people think capital outflows indicate that the yuan will remain weak against the dollar until private-sector confidence recovers.
The European and Japanese central banks are running negative interest rate policies precisely because, with interest rates relatively lower than the dollar, capital flows will induce lower exchange rates and hopefully reflate their economies.
The Fed has exactly the same fear as the People’s Bank in 2009, when China was growing at more than 10 per cent per year. Higher US interest rates would attract higher capital inflows, pushing up the dollar and inducing even higher asset bubbles, with no inflation in sight.
Much will depend on whether the US uses more fiscal stimulative policies and less unconventional monetary policy to revive productivity growth. It looks as if we will have to wait for a new president to make that strategic call.
Andrew Sheng is distinguished fellow of the Asia Global Institute at the University of Hong Kong