The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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November 29, 2006

And So It Begins?

From the Financial Times:

Last week was significant in that the dollar breached an important barrier, according to traders. Since May, it had been relatively stable within a euro trading range of $1.25-$1.30. Its fall outside this range left investors wondering whether that was simply due to a lack of liquidity around the Thanksgiving holiday or the start of a more sustained slide in the US currency...

An even bigger concern is growing talk of global central banks diversifying their foreign exchange reserves away from the US currency. One factor supporting the dollar has been huge purchases by foreign central banks. Since 2001, global currency reserves have soared from $2,000bn to $4,700bn according to the IMF, with two-thirds of the world's stockpiles held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

Anxieties over reserve diversification have been around for at least six months, with central banks in Russia, Switzerland, Italy and the United Arab Emirates announcing plans to cut the proportion of dollars held in their reserves. A shift by central banks away from dollars would remove a key source of financing for the US deficit...

Fan Gang, director of China's National Economic Research Institute and a member of China's monetary policy committee, saw things differently. He said the real problem the world faced was an overvalued dollar, not only against the renminbi but against all the leading currencies.

His comments come at a time when speculation is increasing that China, which is thought to hold 70 per cent of its foreign currency stockpile in dollars, is considering a fundamental change in its reserve allocation. These concerns were highlighted on Friday when Wu Xiaoling, deputy governor of the People's Bank of China, said Asian foreign exchange reserves were at risk from the dollar's fall.

And there is this (hyperlink added):

... Market expectations, monitored by the Federal Reserve Bank of Cleveland, show that investors think there is a 30 per cent chance of a cut in US rates in March.

Just as it seems interest rates in the US may have peaked, they are being increased by the European Central Bank, the Bank of England and the Bank of Japan. The ECB is expected to raise its main rate from 3.25 per cent to 3.5 per cent at its December 7 meeting. The big question is whether Jean-Claude Trichet, ECB president, will signal further increases in 2007.

Here's something to think about.  If the move away from the dollar is for real -- with the presumably inevitable result that current account deficits will not continue to support domestic spending in the United States -- the result will almost certainly be higher U.S. interest rates.  Here's a position, which I endorse, about what that might mean for monetary policy:

We believe that changes in the federal funds rate should be considered on the basis of where economic forces are taking market interest rates, a perspective stemming from several presumptions about the way our economy works. First, “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital.

In other words, if long-term real interest rates rise, monetary policy becomes more expansionary even if the federal funds rate doesn't change.  (This is roughly behind the idea of associating "easy" monetary policy with a steep yield curve, and "tight" policy with a flat yield curve.) That is worth keeping in mind as you read stories like this one:

In another volatile day on the currency markets, the dollar recovered some poise against the euro on Wednesday after an unexpectedly large upward revision to US growth 2.2 per cent in third quarter against an estimated 1.6 per cent and consensus forecasts of a 1.8 per cent rise...

Speaking in New York overnight, Mr Bernanke struck a hawkish tone on US interest rates, saying that inflation in the US remained “uncomfortably high”.

Analysts said that, while it might be something of a surprise that the dollar had failed to derive support from Mr Bernanke’s remarks, he might be in danger of “crying wolf” over US inflationary pressures.

You know, sometimes the wolf is really there.

November 29, 2006 in Exchange Rates and the Dollar , Fed Funds Futures , Federal Reserve and Monetary Policy | Permalink


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Hi Dave,

The reason the USD is going down, and didn't respond to Greenspan, oops, i mean Bernanke (!), is the ongoing adjustment in the US property market. This process has only just begun, not in terms of starts, but in terms of housing competions, which are still near highs. Hence, employment in construction is still high, though with starts down, it has flattened out.

This means that the employment effect is coming in 2007. How big will it be? Who knows (I think bad, but i've been wrong many times before!).

But, what we do know is that, ahead of this process, and with the USD near all time lows, a bad outcome could leave the USD without a rudder and send it tumbling. That's a risk that justifies reducing exposure, or as we do it in hedgefund land, selling the USD.

We also know one other thing. The FED will likely take their time to ease. This process should be a good deal slower than after the stock market crash in 2000. That effect was fast and furious, and the FED a bit slow. Unlike today, the U-rate bottomed in April, the month after stocks turned down. And, the first negative emp report was in June that year. Emp growth has slowed, but it is still positive this time.

So, the longer the process takes, the greater the potential for a nastier eventual outcome. The higher rates stay, the bigger the eventual pressure on housing.

That's why, when Bernanke suggests he is still worried about inflation, the USD didn't bounce. A rate hike, or delay in cuts (as I expect), eventually makes the property adjustment worse not better. And, the downside risks to the USD that much higher.

I hope this helps give a glimpse of how some from the speculative side of the FX arena looks at this issue.


Posted by: andres | November 29, 2006 at 04:15 PM

I personally disagree with Andres, although I'm no expert in the arena. It looks to me as if cost-push inflation is coming in the next few months, with rising wages and little to no increase in productivity. If this occurs with no intervention from the FED to raise interest rates, the USD will slip and, given enough time, foreign bodies will begin to sell their USD, furthering any economic woes the US would have at that point. Of course, I could be entirely wrong on that.


Posted by: Cyrus | November 29, 2006 at 05:46 PM

I agree, the wolf is out there; AG let him out of his cage and he's running loose on Wall ST. Those with kids & grandkids should be very concerned, he eats his young.

Posted by: bailey | November 29, 2006 at 06:31 PM

hahaha, i agree with both of you! Cyrus, it is possible wage inflation will lead to more price inflation.

but, in this case, the outlook for property, and assets in general canget very ugly. higher rates will impinge on property demand at a time of high supply; higher inflation will challenge asset values which are premised on low inflation and low rates. Yikes!

Your case makes the USD look worse, not better.

that's why selling it seems the really good trade, rather than taking a strong view on the outlook for interest rates!

woof woof

Posted by: andres | November 29, 2006 at 08:49 PM

"We believe that changes in the federal funds rate should be considered on the basis of where economic forces are taking market interest rates, a perspective stemming from several presumptions about the way our economy works. First, “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital."

i can clap to this.

it does make some sense to use a moving average or rate of change of the long term yield to at least be a part of the calculation that determines monetary policy.

the bond market is large enough that price/yield manipulation would be difficult to achieve; but something tells me the goldman sachs/hedge funds of the world would still try in order to get access to cheaper capital/liquidity.

but still, i think it's an interesting suggestion...

Posted by: m3 | November 29, 2006 at 11:10 PM

Just look at those Texas janitors getting a 50% (f-i-f-t-y) [That's FIVE, ZERO] pay hike after only a month of bargaining and you know wage inflation is more than andres, Ben and GOD-knows-WHO say it is.
Rates will have to rise to contain this tsunami of inflationary wages and we will just have to face the consequences for the housing market. Those dummies who bought ARMs and sub-primes can go back to camping. Cry me a river, this is about keeping the buck from becoming buckshot.
Interesting amount of foreign relations being conducted by US diplomats at the moment --did Condi take a vacation or what? Most notably Bernanke and Paulson off soon to China on a trade mission, or was that a currency mission? a banking mission? Something.

Posted by: calmo | November 29, 2006 at 11:20 PM

Always remember to check the revisions in any of the horribly skewed financial releases.

Wage compensation has been revised - Compensation up 1.4%, not 7.4%


This maybe another reason the dollar is on its downward spiral. I have a feeling when the revisions for GDP come out, another downward "surprise" will be lurking.

This is not to say that there shouldn't be liquidity/inflation worries, but to enhance them as Bernanke lowers rates soon and does more one day 22 billion dollar coupon passes.

With vendor financing via China and petrodollars looking like bad ROI as the US consumer fades, I expect a greater dollar loss.

Posted by: Alan Greenspend | November 30, 2006 at 08:58 AM

It sure looks like BB's been played like Charlie Brown since the day he signed on. More & more he's looking like a nice guy on a field full of Lucys, unable to apply reason in a world run by rules he doesn't "get".
First, he gets sucker-punched by a dufus cnbc reporter. Then, he takes someone's advice to forget he's always been a straight-shooter, that we all want him to talk gibberish. Then, for some unknown reason he approves an all but toothless credit guidance to his Banks AFTER they publicly confess to absurdly loose lending practices. And now, it's the BEA's turn to pull the football away with a casual oops.
BEA's under Commerce, it's mission is “to foster, promote, and develop the foreign and domestic commerce” of the United States." THEIR job is to help business do more business. Even I know Commerce is just as political as the RNC. So, why is our FED Head "trusting" them, unchecked, to present a credible representation of anything?
On housing, BB has commented that price increases were "driven by fundamentals". He hasn't asked Congress or used his pulpit to call for greater regulatory control over our financial sector, post Glass-Steagall.
He hasn't even cautioned markets not to overread his professed belief that a lot of economic ills can be cured with printing presses. Obviously, the markets are betting big time that Ben will "work" with them.
In a statement last March on the challenges hedge funds present, BB argued that market discipline can work but counterparty risk management is concerning. Concerning? What's the growth rate of credit derivatives? Is anyone reassured because BB's going to China with Hank?
Dave's wonderful Cleveland Fed link ended with a great closing line: "Credibility is the currency of central banks." We ALL trust in the FED to identify and act on the REAL threats to our longterm economic wellbeing. If the scope is now outside FED mandate, we trust it to argue for new regulatory controls. My simple question for BB is, if we can't trust the FED to act for our LONGTERM economic viability, what are our prospects? Personally, I take no solice that BB's going to China with Hank. It's the Administration's & Congress' profligate policies & practices that got us here & it's folly to think there's a win in this for the FED. I just wish BB would learn, the Lucys in his world NEVER change.

Posted by: bailey | November 30, 2006 at 11:31 AM

Well the U.S.A. has a problem: it needs to maintain offshore confidence in the USD so foreign investors will keep providing the cash to fund the U.S. Federal Government Deficit. In this environment the U.S. can't really afford to ease, even if the U.S. economy is going down the toilet. The external constraint is too great.

It's a very fine tight rope to walk and sooner or later they are gonna trip over.

Posted by: Paris_Ib | November 30, 2006 at 01:34 PM

Bailey asks a question of BB: "if we can't trust the FED to act for our LONGTERM economic viability, what are our prospects?"

My question is similar, but twisted to read: "How can we (why should we?) trust the FED to act for our LONGTERM economic viability?" This I ask because the FED keeps coming up with (and being proud of) documents like the one Dave linked us to above that ask us pretty much to "trust them." After all they "are" the experts, no?

We'll I don't trust physicians, engineers, economists or pretty much any of the too-arrogant professional classes. What I want to know from them is what they intend to do when faced with difficult choices (policy and other) and then be able to make my choices accordingly.

What I read from the afformentioned paper http://www.clevelandfed.org/Annual01/essay.pdf was that "central banks ultimately can deliver more economic growth by abandoning preoccupaiton with output gaps (and the like) in favor of a price-stability rhetoric and a policy orientation that meets this objective with the least interference to the natural, dynamic forces of the econmy."

Good luck when the FED seems incapable of even admitting to asset inflation, let alone admitting any complicity in such. I'm probably in a distinct minority, but I trust the ECB more than I do the FED. Or maybe I just don't know enough about the ECB to not trust their rhetoric or policy either.

Posted by: Dave Iverson | November 30, 2006 at 05:30 PM

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