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New York Stock Exchange traders watch Federal Reserve chairman Jerome Powell’s news conference on July 31, 2019. If investors reject the Fed’s narrative that inflation is transitory, then support for US bonds and the dollar will weaken. Photo: Reuters
Opinion
Neal Kimberley
Neal Kimberley

The US Federal Reserve’s monetary course risks leaving the dollar to sink

  • As pent-up consumer demand for imports drives up the US trade deficit amid rising inflation, the Fed’s unchanged policy could seriously hurt the dollar

“Steady as she goes” may be a nautical phrase but it neatly sums up monetary policy settings in the United States after last week’s Federal Open Market Committee meeting. But, to extend the maritime theme, the Federal Reserve’s stance may leave the dollar listing badly.

The US dollar came under some pressure in the post-meeting session, as Fed chairman Jerome Powell said “it is not time yet” to discuss paring back the central bank’s bond-buying programme, even with ample evidence of a US economic rebound from the coronavirus pandemic and amid signs of rising inflation.

The Fed may see inflationary pressures as transitory but investors will have noticed the eye-catching increase in the US gross domestic product deflator in data released last Thursday.

The deflator – a measure of changes in the prices of US goods and services, including exports but not changes in the prices of US imports – rose by 4.1 per cent in the first quarter of this year compared to the previous three months.

As long as overseas buyers of US government bonds continue to buy into the Fed’s interpretation of US inflationary pressures as transitory, their purchases of US government paper indirectly help to support the dollar’s value in the currency markets.

But if they start to reject the Fed narrative and buy fewer US government bonds, or even start selling their holdings in the belief that US inflationary pressure justifies higher Treasury yields and lower Treasury prices, then a pillar of currency market support for the dollar is eroded.

Japan’s finance ministry data shows that Japanese life insurers have been selling foreign bonds for eight months from July last year, the longest stretch of net sales of foreign bonds since data collation started in 2005, and with the proceeds largely moving into yen-denominated domestic bonds.

Given that the US dollar accounts for almost two-thirds of the foreign currency assets of the four largest Japanese life insurers, who alone have US$1.6 trillion of assets under management, these portfolio adjustments are a headwind for the US dollar on the foreign exchanges.

Why US dollar’s puzzling strength amid Covid-19 is only temporary

Japanese life insurers will recover their appetite for US government paper but are also likely to wish to see higher yields first. As it is, the equilibrium in the US government bond market is probably being sustained by the pandemic-related US$120 billion-a-month programme of Fed asset purchases.

This programme will eventually have to be tapered but, in the meantime, it may be keeping US bond prices higher and yields lower than they would ordinarily be, given the inflation data.

At the very least, that programme is injecting large amounts of newly printed dollars into the US money supply, dollars that are not all staying stateside and some of which are probably being sold for other currencies.

Then there is the US goods trade deficit. The US persistently runs a goods trade deficit with the rest of the world, most notably with China.
Source: US Commerce Department

US consumers have a strong appetite for foreign-made goods. Dollars are exported in exchange for imported goods, with those same US dollars historically returning via foreign investment in US assets such as government bonds.

If the pace of that foreign recycling of dollars back into US bonds drops off, it would be logical for the currency markets to conclude that overseas holders of those dollars might also be, to varying degrees, diversifying into other currencies.

US consumer demand is certainly bouncing back from the pandemic. The US trade deficit in goods is expanding at a rate of knots, and dollars are leaving the US as payment for those imports.

US dollar’s fortunes look challenging as pandemic eases

The trade gap in goods climbed 4 per cent to a record high of US$90.6 billion in March, according to the Commerce Department last week, as the US goods imports bill surged 6.8 per cent to a record US$232.6 billion. That is a net US$90.6 billion that flowed out of the US in March alone.

Rising evidence of US inflation might adversely affect foreign demand for US government bonds with the Fed sticking to its monetary game plan to mitigate the economic impact of the pandemic, and just as the release of pent-up US consumer demand for imported goods is driving up the US goods trade deficit.

This does not bode well for the US dollar. It has a sinking feeling about it.

Neal Kimberley is a commentator on macroeconomics and financial markets

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