July 18, 2019

Can the Tail Wag the Dog?​

President Trump disparages China and Europe for “playing big currency manipulation,” meaning deliberately weakening their currencies against the U.S. dollar. Trump, meanwhile, wants to weaken the U.S. dollar to shrink the nation's trade deficit and boost gross domestic product. And there is speculation this may happen. Can he do this and will it be effective?

I don't think so. There are two main ways to force a weaker greenback.

The first is through central bank intervention. This may work for a currency such as the Chinese yuan as its trading volume is still quite low and Chinese authorities have the ability to restrict speculative movements. But it will not work the same way with the U.S. dollar, the reserve currency of the world. Given a daily turnover in the foreign exchange market of $5 trillion, the U.S. central bank's foreign exchange reserves of merely $127 billion are absolutely no match to counter any free-flowing trading forces in the market.

Keep in mind, central bank intervention also occurs during times of extreme volatility, a so-called ''smoothing operation.” Currently, we are experiencing one of the lowest volatility periods in a decade, a reflection of stability and disqualifying any need for intervention. If the U.S. dollar is artificially weakened through intervention, this will only provide investors and corporations a greater opportunity to buy the greenback cheaper, undercutting any intervention effort and may be not best use of taxpayers' money.

An alternative to weaken the U.S. dollar is the use of monetary policy. President Trump criticized the European Central Bank's efforts to further loosen its monetary policy as an act to weaken the euro. He has also criticized the U.S. Federal Reserve for not taking more aggressive monetary measures to weaken the U.S. dollar. Trump's disapproval conflicts with the mandate of the central banks, which is to control inflation not exchange rates. Overshooting to lower interest rates for the sake of currencies may result in future inflationary pressures that suppress long-term economic growth and leave future administrations to deal with the economic ramifications. This is why politicians, who tend to hold myopic economic policy views, should not interfere with central bank policies. It is clear that neither the E.C.B. nor the Fed intended to manipulate currency values.

My View: What needs to be understood is that the U.S. dollar is NOT determined by politicians, but by underlying economic fundamentals that shape stability in the market.

Now, incidentally recent market movements are starting to favor a weaker U.S. dollar. This is based on the lower U.S. interest rates stemming from uncertainties on trade, structural changes within the labor force and debt ceiling issues. This weaker U.S. dollar trend has happened without any physical intervention or excessive monetary easing as President Trump's suggesting. In fact, these policies seem potentially more damaging and may provoke retaliatory behavior from other central banks around the world, creating more chaos than harmony. Let the dog wag the tail, not the other way around.

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