Foreign exchange terminology sounds precise and clinical: authorities “intervene” and then “sterilize.” In practice, FX is very messy. It feels like there are ten doctors operating on a patient at the same time without knowing what the others are doing. In the late 1990s, the U.S. tried to better manage its policy by giving primary responsibility to the Treasury Department. 1 1 Close The New York Federal Reserve does still remain involved in the execution of currency intervention. Since then, U.S. policy has become more passive, with only two episodes of intervention in the past twenty years. 2 2 Close One was in 2000 to strengthen the euro. The other was to weaken the yen in 2011 after the Fukushima Daiichi nuclear disaster. Other countries such as Switzerland and China have been very active during the same twenty-year period. It is possible that the U.S. policymakers have learned to respect the ability of markets to properly determine exchange rates and allocate capital, or more likely, they feel direct intervention is not worth the hassle. This view may be changing. Last week Treasury Secretary Steven Mnuchin refused to rule out currency intervention as a policy tool. He said that there is no change to the strong dollar policy but added three crucial words: “as of now.” 3 3 Close My government to English translator says that means “we are seriously considering it, we just have to figure out how to do it first.” , 4 4 Close Bloomberg: Mnuchin Says No Change to U.S. Dollar Policy As of Now, 7/18/19. Some of his colleagues have tried to walk it back, but it will likely persist in the back of investors’ minds in the coming months.
The line between foreign exchange policy and economic policy is blurry. Traditional economic tools such as fiscal spending, tax policy, interest rates, and investment incentives can affect exchange rates. When these indirect measures prove inadequate, authorities can turn to capital controls, which prevent companies and investors from freely moving currency. While they are used with some frequency in emerging markets, most developed economies have avoided using them. Mnuchin probably isn’t thinking about capital controls. He is thinking about an even more direct tool known as currency intervention.
In a currency intervention, the government or central bank goes into the market and buys or sells its own currency. In theory, currency interventions should succeed because the big bad government (or quasi-governmental institution) can overwhelm the poor little market participants. The reality has been far less encouraging. Governments conducting FX interventions have been like the big bad wolf: there is a lot of huffing and puffing, but only sometimes does the house blow down.
One key factor in determining the success of an intervention is the level of coordination with countries and economic agents. If every country agrees to intervene and synchronize their economic policies, they should be able to achieve the exchange rates they want. For example, the famous Plaza Accord of 1985 was successful in reversing the U.S. dollar’s appreciation through coordinated intervention and monetary policy. It was so successful that two years later the same governments agreed that they needed to stop the dollar from depreciating in what became known as the Louvre Accord. 5 5 Close That was not as successful. In October of 1987, U.S. Treasury Secretary James Baker accused Germany of reneging on the agreement and said in colorful language that he didn’t care if the dollar fell sharply. The stock market crash of 1987 followed. It is controversial as to what role that played in causing the crash. I will say it is a more plausible explanation than some of the theories thrown around these days. One comedy on Showtime blames early quants, but that is fiction. And fiction that no one is watching so I don’t know why I brought it up.
When countries act unilaterally, they often fail. In the mid 1990s, repeated interventions did not stop the U.S. dollar from falling against other major currencies. Defending a domestic currency presents some technical challenges. In order to buy its own currency, a country must sell some foreign currency to offset it. Governments and central banks store up reserves for this purpose, but they are not infinite. When reserves start to run low, speculators and hedgers may think the government is running out of ammunition for intervention and panic. This happened en masse during the Asian financial crisis of 1997, and there were some sharp moves in currencies. In the 1990s, the U.S. didn’t run out of reserves, but it didn’t use enough of them to stop the dollar from falling.
It would seem to be easier to intervene to depreciate your own currency. Keeping a currency strong is like keeping your car on the road – it is a task that requires constant attention and properly maintained equipment. Knocking a currency down is more like driving the car off the road: a country has to convince people around the world that its economic policies make it an unattractive place to invest. If there is one thing many governments are good at, it’s convincing people that their economic policies are unsatisfactory. When governments intervene against their currency, they have unlimited resources. They can print as much of their own currency as they need to buy foreign currency. But as Switzerland has shown, even with unlimited resources they don’t always succeed.
Two things happen when a government entity prints money and sells its currency. One is that it acquires foreign currency, which it then has to manage on its balance sheet. This task proved more than a match for the Swiss National Bank in 2015. The other is that all of the printed money can affect the domestic economy. Often the central bank can take measures known as sterilization to offset the increases in money supply, but this process can be technically difficult and has its disadvantages. 6 6 Close Not to get too technical, but sterilization requires aggressive action in the money markets, which aren’t always liquid enough to accommodate it. China ran into that issue when it was intervening against the yuan in the mid 2000s. A country with open flow of capital can’t control its exchange rate and have independent monetary policy, because the act of maintaining the currency at a level affects interest rates and money supply. Economists have a clever name for the dilemma of having to manage three diverging outcomes. They call it a “trilemma.” 7 7 Close Tri + dilemma = trilemma. Some economists express the trilemma as saying that it means a country can’t have an independent monetary policy, a fixed exchange rate and free flow of capital.
This morning, White House advisor Larry Kudlow said that the administration has “ruled out” currency intervention as a matter of policy. 8 8 Close Bloomberg: “Kudlow Says White House Has Ruled Out Currency Intervention,” 7/26/19. Normally, this would be the end of discussion on the topic, but don’t be so sure it won’t come back. The executive branch has been dissatisfied that the Fed has not cut rates as aggressively as it would like. If the Fed does not cut rates aggressively, the Treasury may decide to dust off its old tools. Currency intervention could be seen as a backdoor way of loosening monetary policy. 9 9 Close Several years ago, a Brazilian politician accused the U.S. of using monetary policy as a backdoor way of influencing currency and starting a currency war. This would be the opposite. A stronger dollar and worsening trade conflicts would be preconditions for action. U.S. policy can be unpredictable, so investors should be prepared even for unlikely outcomes even ones that have supposedly been ruled out.
What We Are Watching
Bank of Japan Meeting (Tuesday) With the Fed and the ECB moving in a dovish direction, there is rising market focus on the Bank of Japan’s next policy move. The slowdown in global trade has produced a noticeable deterioration in manufacturing sentiment and industrial production in Japan. Consumer confidence has fallen to multi-year lows and households face a Consumption Tax increase later this year. Against this backdrop, achieving the BoJ’s inflation target may be challenging without additional easing. Market pricing suggests little expectation of a rate cut at the July meeting, but any changes to the BoJ’s forward guidance hinting at a near-term rate cut or changes to QE could presage policy changes ahead. This could support Japanese bonds and weaken the yen.
FOMC Meeting (Wednesday)Policymakers left rates unchanged at the FOMC meeting in June but delivered dovish guidance for the future. The post-meeting statement noted rising economic uncertainty and assured that the central bank would “act as appropriate to sustain the expansion.” 10 10 Close FOMC Statement, 6/19/19. The Summary of Economic Projections (SEP) showed nearly half of meeting participants expected to cut rates by the end of the year. Chair Powell added to expectations for easing at his semi-annual Congressional testimony earlier this month, noting that “uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.” 11 11 Close Chair Powell: “Semiannual Monetary Policy Report to the Congress,” 7/10/19. A majority of forecasters surveyed by Bloomberg now expect a 0.25% rate cut at the July FOMC meeting, while markets price in some chance of a larger 0.50% cut. 12 12 Close Fed Funds futures pricing from Bloomberg as of 7/25/19. In the past, the Fed has taken an asymmetric approach to cuts and hikes, with a greater willingness to move aggressively when easing policy. Nonetheless, it is unclear if officials are sufficiently worried about U.S. growth to deliver a 0.50% cut. If the committee announces a smaller cut, market reaction may depend on the tone of forward guidance. If such a move is not accompanied by a clear signal of additional easing, it could be perceived as hawkish, pressuring stocks and bonds and boosting the dollar.
U.S. Employment Report (Friday)U.S. nonfarm payroll data surprised to the upside last month, easing fears of a broader slowdown in the U.S. economy. Although jobs gains have remained strong, averaging 192,000 over the past twelve months, wage growth has slowed and a stable participation rate has kept the unemployment rate supported at 3.6%-3.7% over the last few months. 13 13 Close Bureau of Labor Statistics. The stable participation rate points to broad labor market improvement, as the retiring baby-boom generation has been expected to weigh on participation. On the other hand, individuals returning to the labor force may be one factor helping to keep wage growth contained. This week’s data for July will follow Wednesday’s Fed meeting, so its implications for policy may relate mostly to potential action later this year. An upside surprise in payrolls or wage data could help to reduce expectations for further easing.