The United States Needs To Face The World With A Strong Dollar

by: John M. Mason

Summary
 
Many officials and economists around the world are calling for the Fed to resist raising short-term interest rates due to the turmoil in emerging markets.
       
The world is changing, however, and the United States is going to be facing different challenges as it moves forward, especially from the Chinese and, hopefully, from the Europeans.
       
This new economic era is going to require the United States to support a strong dollar. It needs to get started on this right now.

The Wall Street Journal's lead editorial the other day carried the title "Emerging Market Rip Tide." I think that the editorial was "spot on." The editorial blamed the Federal Reserve for the mess that we now observe in the emerging markets. I have written my own take on the emerging markets crisis.

This crisis, along with the possibility that the Federal Reserve will raise short-term interest rates at its September meeting, has many people around the world in a tizzy.

The chief economist at the World Bank has warned that "The US Federal Reserve risks triggering 'panic and turmoil' in emerging markets if it opts to raise rates at its September meeting and should hold fire until the global economy is on surer footing…" How did the emerging markets get into such a situation?

Well, the Wall Street Journal has an answer for this:
"Emerging markets are often subject to cyclical capital flows. The Fed exacerbated this beginning in late 2010 with its second and third rounds of quantitative easing…
The QE policy succeeded in driving down the value of the US dollar…But, it did so by making the dollar into a funding currency for investments overseas. Investors borrowed dollars at low rates, converted them into other currencies and bought assets with higher return, a phenomenon known as a carry trade 
This cross-border flow fed booms in emerging markets…"
The Fed has ended quantitative easing and now wants to return to a more "normal" level of interest rates.

Now the rest of the world is in a panic. Not only has the World Bank objected, but Christine Lagarde, managing director of the IMF, has put in her two cents against the Fed raising rates. And other commentators about the world, like former Treasury Secretary Larry Summers and Financial Times lead economics writer Martin Wolf, have added their voices.

The problem is that the world has changed. The United States has a strong dollar, one of the strongest in the world. The euro/US dollar relationship perhaps gets the most attention and here the value of the dollar has risen from about € 0.71 to the dollar to about € 0.91 to the dollar, a rise of over 28 percent.

In terms of currency indexes, the Fed's Trade Weighted US Dollar Index against major currencies has risen from about 76 in early July 2014 to the 91 to 92 range, roughly a 21 percent increase.

The Fed's Trade Weighted US Dollar Index against other major trading partners, which includes most of the currencies from emerging markets, has risen from about 130 in early July 2014 to its current level around 150, a rise of over 15 percent.

Anyway you cut it, the US dollar is now one of the stronger currencies around. And, this is the problem. The dollar is in such a strong position because its economy, as weak as its growth is, is one of the better performing economies in the world. As a consequence, most of the central banks in other countries are following some kind of an easy monetary policy, or even, in several, are following a policy of quantitative easing.

Thus, the United States economy appears to be out of sync with the rest of the world. If this is true, and the Fed begins to raise short-term interest rates, the dollar will become even stronger and this will be, it is argued, very harmful to these other nations that are really struggling now and facing deflation, if not just recession.

This puts the United States in a very awkward position.

But, there is another problem that is starting to show its head. Over the past seventy years or so, the United States has been the economic hegemon of the world. The United States, according to the Wall Street Journal editorial, has been the "custodian of the world's reserve currency."

However, "The QE era shows what happens when it ignores the latter responsibility." The world we are moving into is not one of economic hegemony. The world is moving into a situation where several currencies are going to be competing to be the strongest, most trusted currency in the world, and this means that a lot of things are going to change.

The Federal Reserve will not be able to conduct a policy that will lead to a secular depreciation in the value of the US dollar, something it has done since the early 1960s. Rather than support a weak currency, the Fed is going to have to pursue a strong dollar.

And, it will need to do so because the Chinese are going to be competing for a world leadership position with their renminbi. Also, the Europeans will be back in the game trying to achieve a strong euro, as soon as eurozone economies turn themselves around. The Germans will be sure of that.

Furthermore, you can bet, there will be other countries trying to get into this game as well. Things are going to be different. They are changing as you read this. This is going to change how the Fed looks at the world. It is going to change how the Fed acts in the world.

The Federal Reserve needs to support a strong dollar. It needs to begin that right now…and make the world aware of the fact that it is changing how it operates. The foreign currency markets tell us a lot about how they think the Fed should act.

The value of the euro has traded around $1.10 this spring and summer. When it appears as if the Fed is going to begin to raise short-term interest rates, the value of the euro declines. It has declined toward $1.05 and some of us believe that it should get to parity, one euro for one dollar.

When it appears as if the Fed is going to back off raising rates, the value of the euro rises and the value of the dollar declines. In the recent financial market movements, the euro has risen above $1.15.

It appears to me that financial markets want the Federal Reserve to raise interest rates.

Financial markets, I believe, wants the United States to step up and support the stronger dollar.

I believe that this is a picture of the future. The financial markets want a strong dollar to match off against the Chinese renminbi…and eventually, again, the euro. I want a strong dollar to match as well. Hopefully, officials at the Fed will begin to see this picture.

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