October 17, 2010 6:19 pm
The likelihood that the Federal Reserve will soon launch more quantitative easing, something that tends to weaken the dollar, has prompted warnings of a currency war from countries that feel their exports will be menaced by a weaker greenback.
But if the estimates of many economic models are correct, the dollar might already have fallen far enough.
To work out how much a fresh round of QE would affect the dollar it is necessary to answer three questions. How much would, say, $1,000bn of QE lower long-term interest rates? How much do lower long-term interest rates weaken the dollar? And how large a fall in the dollar has already been built into the market price?
Economists have not had much practice with QE and admit that their estimates are not robust but a number of studies of the Fed’s 2008 and 2009 purchases suggest that $1,000bn of QE might lower 10-year Treasury yields 30 basis points. A few suggest the effect might be as high as 50bp.
Joel Prakken of the research firm Macroeconomic Advisers says that, in his model, a 50bp fall in 10-year rates “ends up reducing the dollar by about 2 per cent”.
According to a 1999 research paper on the Fed’s own economic model, a change in policy that leaves 10-year rates 50bp lower after two years causes a 5 per cent fall in the dollar. It also raises output 1.7 per cent and increases inflation 0.6 per cent during the same period.
The Fed declined to give updated estimates or say whether the 1999 numbers were applicable to the current situation.
Christopher Neely of the St Louis Fed has studied how much the dollar fell on days when the Fed announced its asset purchases in 2008 and 2009. He found a total drop of about 6.5 per cent for the $1,725bn programme.
Scaling that for a $1,000bn round of QE would give 3.8 per cent. Almost every fundamental estimate therefore suggests a 2-5 per cent fall in the dollar and most likely towards the bottom of that range.
Yet since Fed chairman Ben Bernanke gave his speech at Jackson Hole at the end of August – the point at which markets began to anticipate another round of QE – the dollar has declined more than 4 per cent against an index of other currencies.
Currencies tend to follow trends and they also tend to go too far in one direction or another once they start to move.
All of these studies, however, suggest that, unless a new round of QE is very large, the dollar may not have much further to fall.
The Fed does not care much one way or the other.
All Fed officials say the dollar is a matter for the Treasury – but a weaker dollar is always one route by which looser monetary policy acts to spur the economy. In the 1999 paper on the Fed’s economic model, a weaker dollar accounts for 17 per cent of the eventual boost to growth.
Mr Bernanke declared on Friday that inflation was too low. But he has also repeatedly said he will not countenance any increase in the Fed’s inflation goal of “about 2 per cent or a little below”. As long as there is no big rise in inflation there is no reason to expect a bigger-than-usual fall in the dollar.
There are a couple of provisos. If the Fed were to adopt a “price level” target, as mooted by some officials, that would probably mean cumulative inflation during the next few years a few percentage points higher than it otherwise would be. That remains unlikely but could lead to a larger decline in the dollar.
The Fed could also end up doing more than $1,000bn in extra QE.
The Treasury, for its part, feels that its counterparts in other countries sometimes fail to appreciate just how independent the Fed is. The two institutions would co-operate over the dollar only in the most extreme circumstances.
If the rest of the world expects the US to stay its hand on QE out of concern for the dollar, it is likely to be disappointed.
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