How the Federal Reserve’s monetary policy is setting up the US dollar for a fall

Decision-makers in Washington appear less enthusiastic about having a strong US dollar to encourage consumers to buy goods made overseas
China may have to get used to the idea of a further rise in the yuan against the US currency, even though it may not welcome the prospect

Neal Kimberley

Published: 5:50am, 8 Sep, 2021

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The Chinese yuan has performed well versus the US dollar in the past 12 months, even as the broader value of the dollar has held up pretty well against major currencies.

Whether China would welcome a further rise in the yuan against the US currency is questionable, but it is something Beijing might have to face as current US policy settings could be lining up the dollar for a fall.

On the Chinese side of the dollar-yuan equation, China’s export sector will gain from a slightly weaker yuan. Some economists are warning that recent declines in purchasing managers’ indices suggest China’s economy is facing headwinds that extend beyond the effects of recent Delta variant outbreaks.

There is also an argument that a degree of yuan weakness might be a logical outcome if international investors become unnerved by the potential implications of changing policies in Beijing. However, the emphasis should be placed less on the yuan aspect of the equation and more on the US dollar side.

In a world where globalisation was perceived by Washington as a net benefit for the US economy, a degree of dollar strength which gets American buyers more bang for their buck when purchasing goods made overseas has a certain appeal.

But with the United States and China now at odds on many issues and with US politicians – both Democrats and Republicans – having increasingly identified the Chinese economy as the true winner from globalisation, Washington appears less enthusiastic about the concept.

US President Joe Biden’s “ Build Back Better” plan might have succeeded Donald Trump’s “ America first” agenda, but the commonality between the two is the emphasis on rebuilding the US industrial base. Washington might feel that a more competitively priced dollar, which would help US exporters and encourage import substitution by US consumers, would encourage the reshoring of jobs.

No one should realistically expect the Biden administration to publicly embrace the notion of dollar weakness. However, the currency markets will price the US dollar based on what Washington does, not what it says.

If nothing else, as recent events in Afghanistan have shown, the US acts in what it perceives to be America’s interest when push comes to shove, regardless of what others might think.

In a twist of fate, the fall of Kabul to the Taliban on August 15 occurred on the same date 50 years after another US decision that suited American interests but drew criticism – the Nixon shock of 1971.

The repercussions from the Biden administration’s decision to end the 20-year presence of US forces in Afghanistan are as yet unknowable, but the devaluation of the dollar following Richard Nixon’s decision to end the its convertibility to gold is now a matter of historical record.

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Nixon acted because Washington knew that if international holders of dollars – increasingly unnerved by the cost of US military involvement in Southeast Asia and amid signs of rising US inflation – were to exercise their right to convert dollars to gold at US$35 an ounce under the 1944 Bretton Woods Agreement, the US would not have enough gold to go around.

America’s allies were not happy with Nixon’s decision, but he took the view that devaluing the dollar was the least unpalatable option for the country and for his own re-election prospects in 1972.

In the era of free-floating exchange rates, markets set prices but take a lead from policy, most notably monetary policy.

As it stands in the US, the Federal Reserve now has an average inflation target of 2 per cent. As the Fed has confirmed, that means after a long period where US inflation was below 2 per cent, the US central bank will tolerate some degree of inflation above that level.

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But when sub-target inflation is followed by a period of above-target price rises, adhering to the inflation target concept surely means US benchmark interest rates end up being lower than markets might ordinarily expect as the Fed bides its time before tightening policy.

That could unnerve the currency markets. Oliver Brennan, senior macro strategist at London-based independent research provider TS Lombard, wrote last week that he felt the Fed’s policy stance “is now explicitly [US] dollar-negative”.

The US dollar side of the dollar-yuan equation might currently carry the greater weight, and while China might not need a stronger yuan, the case for US dollar weakness feels increasingly persuasive.

Neal Kimberley is a commentator on macroeconomics and financial markets