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When Doves Cry: Bedeviled By Dollar "Dilemma", Trapped Fed Faces FX Catch-22

Last Thursday, Janet Yellen revealed something "shocking". As it turns out, monetary policy impacts exchange rates! Who would have thought? Here’s the exchange with BBC’s Michelle Ferry:

Ferry: You talked a lot about the strong dollar I wondered do you see your policy actions affecting the dollar? Is it something you consider when you're making your policy decisions?


Yellen: So monetary policy, U.S. monetary policy is directed toward trying to achieve the goals that Congress has laid out for us. When monetary policy tightens and interest rates rise, it commonly is the case, either when it happens or in expectation, the expectation that that's coming. Interest rate differentials globally do tend to induce capital flows that have impacts on exchange rates. 


So monetary policy often has some effect on the exchange rate. And it's not in my view the main channel by which monetary policy works. It's one of a number of different channels by which monetary policy works. But it does have some impact on exchange rates and of course yes we need to take that into account.

Why yes, monetary policy does have “some” effect on the exchange rate and despite Yellen’s deliberate attempt to act as though Ferry’s question came completely out of left field, and the ridiculous communiqué that came out of the G20 meeting in Ankara earlier this month notwithstanding, there’s a global currency war going on and the collective central banker effort to throw a tarp over the elephant sitting in the corner of the room looks ever more ridiculous with each passing policy meeting. Here’s an example of what we mean, from Riksbank Governor Stefan Ingves on September 3:

“Any rapid strengthening of krona would pose risk to inflation rise. Riksbank won’t be passive if ECB makes big changes in its policy.”

In short, round after round of competitive easing and the attendant global currency wars have forced central bankers to become FX strategists, a development Goldman says “signals something important.” And while the ECB, Riksbank, SNB, and BoJ struggle to find more ways to ease in a desperate attempt to push down their currencies and boost flatlining inflation expectations, and as LatAm ponders the implementation of pro-cyclical policies in order to keep their inflation targets anchored in the face of the pass-through threat from plunging currencies, Janet Yellen is faced with the unenviable task of trying to figure out how to conduct Fed policy without doing something that torpedoes everyone. Here's Goldman with more on the Fed's "basic dilemma": 

When central bankers start talking like FX strategists, it can signal something important. One example is the ECB press conference in August 2014, when President Draghi began talking about CFTC positioning, citing building Euro shorts as evidence that monetary policy divergence would pull the single currency lower. Coming after a June press conference when President Draghi almost dared the Euro to rise, this comment sparked our interest, because it signaled greater focus on Euro downside, and – in the event – it was closely followed by the surprise deposit cut in September and subsequent march towards QE. Chair Yellen this week reminded us of that moment. At one point in the press conference, commenting on Dollar appreciation pressure, she said that expectations for lift-off are moving interest differentials in favor of the greenback, inducing capital flows and Dollar strength. Rate differentials and an implied Dollar stronger forecast have not previously made it into Chair Yellen’s press conferences, which – together with her frequent mentions of USD (Exhibits 1 and 2) – signals greater focus on the greenback and, perhaps, growing apprehension over further Dollar appreciation. We had flagged this risk in our last FX Views, which we had called “Dollar versus Data Dependence” for that reason, and the market is now debating whether the Fed’s reaction function has changed. 


So what does this mean going forward, you ask? Well, essentially the Fed needs to avoid causing the dollar to soar because excessive USD strength would (almost) invariably trigger a meltdown in EM. The pressure on commodity currencies combined with idiosyncratic political risks (e.g. Turkey and Brazil) has EM on the precipice - a Fed hike could very well be enough to push them over the edge and as Deutsche Bank noted over the weekend (and as Citi didn’t seem to understand going into last week’s FOMC meeting), an outright EM meltdown would feed back quickly into advanced economies causing the Fed to frantically reverse course. As Deutsche Bank put it “the developments in EM have been negative for risk and, if conditions deteriorate further, the net result could be in a nontrivial adverse impact on DM economies - rate hikes and further USD strength could have made things considerably worse.” 

Now back to Goldman:

The Fed is struggling with a basic dilemma: how to normalize US monetary policy without the Dollar going through the roof. We have in the past estimated that policy normalization in the US could push the Dollar 15 percent stronger, which – together with our expectation for additional easing from the ECB and BoJ – is why we forecast the Dollar to rise more than 20 percent through end-2017. This kind of upside is probably difficult for any FOMC member to accept – even the hawks – and Fed attitudes towards the Dollar have seen some twists and turns as a result. The most relevant for today came last fall, when NY Fed President Dudley gave an interview shortly after the September FOMC, in which he flagged risks to growth from the Dollar rise. Vice Chair Fischer repeated that message in early October. Markets, taking their cue from the Fed, began to worry about growth, risk appetite weakened, which culminated in the flash crash on Oct. 15. After that, the Fed switched to a more constructive message, removing the reference to “significant underutilization” at the October meeting (which was only added in July) and spent the rest of the year talking up the economy. Risk appetite rebounded and the SPX rose 10 percent from its October low. This episode highlights an important dilemma facing the Fed: shifting dovish means talking up growth risks to the US economy (which this week came in the form of China and emerging markets). That can hurt risk appetite, driving stocks down and tightening financial conditions. Last fall, the Fed ultimately backed away from that strategy and accepted Dollar strength as it downgraded forward guidance. We think the outcome will be the same this time around. 

In other words, the Fed has to choose between keeping a lid on USD strength by staying dovish, or resurrecting domestic risk appetite by telegraphing more confidence in the economy.

And here we see how the Fed’s new reaction function has immeasurably complicated things. That is, in order to keep from exacerbating EM market turmoil, the Fed was forced to lean dovish. But by doing so, it caused risk to sell off at home which, as Goldman notes, “is obviously the opposite of what the Federal Reserve wishes to accomplish.” Here are Goldman's summary bullets:

  • Last week was noteworthy because a dovish Fed caused risk to sell off.
  • The underlying tension is a Fed that is struggling to deal with a strong Dollar.
  • Talking down the greenback by shifting dovish requires talking down the economy, ...
  • which Chair Yellen did last week by flagging risks from weakening China and EMs.
  • The danger in such a message is that risk sells off, tightening financial conditions, ...
  • which is obviously the opposite of what the Federal Reserve wishes to accomplish.

The only way to counter that undesirable outcome is to talk up the economy and accept dollar strength but then that’s exactly what the Fed was trying to avoid doing in September because the committee knew it would trigger an EM meltdown. The new reaction function seems to involve sensitivity to both domestic and global financial markets. In the current environment where a positive assessment of the outlook for the US economy is required to keep a bid under risk assets (i.e. in an environment where good news is good news again) but in which EM is one "symbolic" Fed hike away from careening headlong into crisis, the new reaction function can’t possibly work. 

Amusingly, there is a way out. The Fed could do as Goldman's FX strategy team suggests they will and talk up the economy thus tacitly accepting inevtiable dollar strength, hike, watch EM plunge into crisis, wait for said crisis to feed back into the US economy, then use that as an excuse to launch QE4. Mission accomplished.