From zero to one, then back to zero

Economists’ evolving understanding of the zero-rate liquidity trap

MY COLUMN this week sets out three possible scenarios for the American economy in 2016, in the aftermath of the Fed's first rate hike in more than nine years. Each scenario corresponds to an understanding of why it is that near-zero interest rates are so difficult to leave behind; economies eventually managed the trick in the decades after the Depression, but those that have sunk to the zero lower bound in recent years have been unable to escape it for long. 

What strikes me as interesting, and what motivated the column, is that our understanding of the pull of near-zero rates has evolved since late 2008, and continues to evolve, in a very ominous direction.

Back in late 2008 and early 2009, when rates around the rich world fell below 1%, the framework most economists reached for was what you might call the traditional Hicks-Krugman story of the liquidity trap. John Hicks's analysis of the work of John Maynard Keynes first set out the concept of a liquidity trap in 1937. Paul Krugman borrowed and updated that framework in 1998 in an analysis of the Japanese economy. This story is one in which a really nasty economic shock knocks an economy into a bad equilibrium; rates fall to zero, at which point monetary policy loses its punch. Real rates can't go low enough to stimulate the economy, which remains stuck with a shortfall in demand. To get out, the government either needs to borrow heavily and spend to boost demand, or the central bank needs to promise to tolerate high inflation once, at some point in the distant future, the economy returns to health: to "credibly promise to be irresponsible", in Mr Krugman's phrase.

Higher exected inflation reduces the real interest rate in the present, providing the needed stimulative jolt. In his paper, Mr Krugman mused that a target of 4% inflation for fifteen years might be the sort of thing needed to get Japan out of its trap—assuming Japanese households would find such a target credible.

An alternative view emerged over the course of the recession and recovery, which one might call the Friedman-Schwartz-Bernanke story. In the Monetary History of the United States, Milton Friedman and Anna Schwartz argued that monetary policy had not been helpless in the 1930s, and that in fact the blame for the depth and length of the Depression should be set at the feet of the Federal Reserve, which tolerated a dramatic drop in the money supply. Ben Bernanke's Fed adopted a version of this framework, which continues to shape policy today: that a liquidity trap is only a trap for an insufficiently aggressive central bank. Use enough unconventional monetary policy, and the trap can be overcome. And so the Fed never attempted to gin up any sort of regime change, or to dramatically increase the market's expectations for future inflation. Instead, it used QE and promises to keep rates low for as long as necessary to support demand. And the Fed now seems confident that, having generated a robust-enough recovery, it is safe to move away from zero, as nonchalantly as if one were raising rates from 4% to 4.25%.

That view is almost certainly wrong. Other rich-world central banks with other robust-enough recoveries have tried and failed to sidle away from zero; it doesn't work. Markets don't think it will work this time; futures markets project a path for the federal funds rate about half as steep as the (already gentle) path that the Fed suggests it will follow.

At the same time, the traditional liquidity trap story also looks inadequate.

America has enjoyed a relatively robust recovery, at least over the last year or two, despite big government budget cuts and inflation rates, both actual and expected, barely above zero. And meanwhile other economies around the world, which performed reasonably well during the dark period from 2008-2010, are finding themselves drawn toward the zero lower bound.

And so a new narrative is gaining adherents (among them Mr Krugman himself): the Hansen-Summers "secular stagnation" story of low rates forever. The story, I write in my column goes like this:
[T]he problem is a global glut of savings relative to attractive investment options. This glut of capital has steadily and relentlessly pushed real interest rates around the world towards zero.
The savings-investment mismatch has several causes. Dampened expectations for long-run growth, thanks to everything from ageing to reductions in capital spending enabled by new technology, are squeezing investment. At the same time soaring inequality, which concentrates income in the hands of people who tend to save, along with a hunger for safe assets in a world of massive and volatile capital flows, boosts saving. The result is a shortfall in global demand that sucks ever more of the world economy into the zero-rate trap.
The long downward trend in global real interest rates pre-dates the Great Recession. In the early 2000s the Fed was already struggling to manage a low-rate, low-inflation environment.

The glut of global savings in search of safe assets with a reasonable rate of return fueled the American housing bubble. The financial crisis ushered rich-world rates to the zero lower bound, but the fall to zero was probably inevitable. What's more, it is only a matter of time until the rest of the world gets stuck as well:
Economies with the biggest piles of savings relative to investment—such as China and the euro area—export their excess capital abroad, and as a consequence run large current-account surpluses. Those surpluses drain demand from healthier economies, as consumers’ spending is redirected abroad. Low rates reduce central banks’ capacity to offset this drag, and the long-run nature of the problem means that promises to let inflation run wild in the future are less credible than ever.
This story, which looks increasingly convincing, implies that as the Fed attempts to raise rates the dollar will rise in value and inflation will remain low. The American economy will sputter and stall, forcing a quick reversal in rates—though it might keep growing for a time if the government and households tap the money flowing their way and borrow to fuel consumption (or real estate investment). 

If this narrative is the right one, an aggressive-enough central bank can ameliorate the zero-rate problem but cannot solve it. A higher inflation rate would allow an economy to maintain positive nominal interest rates in a world in which the global real rate stays rooted near zero.

Modestly ambitious monetary policy that depreciates the currency will boost an economy, but mostly by capturing demand from other countries. Economies that have had enough can adopt capital controls to keep the tide of savings out and regain monetary-policy independence. None of that is especially satisfying. But a proper, sustainable long-run solution would require a fix to the global savings-investment imbalance. That, in turn, might mean dramatic reforms around the world, much higher rates of immigration to rich countries with shrinking workforces, and heavy borrowing by safe-asset issuing governments. 

The secular stagnation picture is a grim one. It might be wrong; maybe America's economy will keep on trucking even as the Fed lifts rates. If America finds itself dragged slowly back to zero, the outlook for the global economy over the next decade or so is an uncertain and worrying one.

The political shocks that will define 2016

Look to China and Britain for sudden surprises
James Ferguson illustration, Crystal Ball, Earth
When judging forecasts about 2016, beware of the “continuity bias”. This is the temptation to assume that this year will be a bit like last year — only more so. In fact, recent political history suggests that the events that define a year tend to be the big surprises and sudden discontinuities (call them “black swans” or “unknown unknowns”, if you must).
At the beginning of 2014, no pundit that I know of was predicting that Russia would annex Crimea or that a jihadist group called Isis would capture Mosul, Iraq’s second-largest city.

And, at the start of 2015, I cannot remember many people predicting that more than 1m refugees would arrive in Germany that year, or foreseeing the improbable rise of Donald Trump in the US.

All this suggests that the most important geopolitical events of 2016 will also be something that the pundits and politicians are not yet talking about. Predicting the unpredictable is a fool’s game — but one I intend to play, nonetheless. The best approach, I think, is to look for potential discontinuities rather than “more of the same”.

The best place to look for a sudden surprise in 2016 could be China. One of the keys to Chinese success over the past 25 years is that the government has managed to keep economics exciting and politics boring. That could change this year.

President Xi Jinping’s anti-corruption campaign is sweeping up some of the most powerful and richest people in China — senior generals, the head of China’s internal security service, billionaires, chief executives, television personalities.

All this is taking place against the background of a slowing economy, a crackdown on free expression and widespread public anxiety about pollution and industrial accidents. Beneath the calm official exterior of Chinese politics, the potential for a backlash, either from the public or from some of the groups threatened by the anti-corruption campaign, is surely growing.

Of course, the safe bet is that President Xi will still be in place this time next year. But if the Chinese leader’s position does come under threat this year, the pundits will swiftly queue up to explain why, in retrospect, it was obvious that something had to give.

In 2016, the election of Hillary Clinton as US president would represent continuity. She is a known quantity, favoured by the US establishment, well-funded and ahead in the polls. The “continuity bias” is also leading almost all pundits to dismiss the presidential election chances of Donald Trump. History suggests that candidates like Mr Trump eventually always crash and burn.
But such analyses involve discounting the possibility that the rise of Mr Trump is a symptom that something fundamental is changing in the US. It also entails discounting the truly impressive opinion poll lead that “the Donald” has built up in the race for the Republican nomination. I am enough of an establishment creature to find it very hard to envisage Mr Trump winning the presidency itself. But I believe the polls that suggest that he is favourite to be the Republican candidate. That, in itself, would be a political earthquake.

The big discontinuity in Europe this year would be if Britain defied conventional wisdom and voted to leave the EU. The bookmakers still place the odds of Brexit at about one in three — and they are an unsentimental bunch. But set against this, the economic and political backdrop for a British referendum on Europe is distinctly unpromising.
The EU is a tough sell at the moment. It is struggling economically, is politically divided and cannot agree on a strategy to deal with the refugees and migrants coming into Europe. That plays directly to Brexit supporters’ most politically potent issue — immigration.

A lot of political forecasts about Europe outside the UK are also based on the assumption that the EU will find an effective strategy for the refugee crisis over the coming year. But that looks like wishful thinking.
The objective factors driving refugee flows — war in the Middle East, the hope of a better life in Europe, the profits involved in people-smuggling — will all still be there in 2016. If refugee flows continue at current levels or even intensify in 2016, then the political effects on the EU could be quite dire, threatening the position of Chancellor Angela Merkel in Berlin and creating deeper divisions between Germany and its European partners.
Is there anything that could go unexpectedly right in 2016? Absolutely. One strong possibility is that Isis will suffer serious military setbacks over the course of the next 12 months, at least in Iraq and Syria. (It may continue to expand in Libya and north Africa.)

The horror provoked by the terrorist attack in Paris in November served to disguise the fact that the jihadis have actually been losing territory in recent weeks and months. The Iraqi army, backed by western air strikes, has just succeeded in retaking Ramadi. In 2016 it should make further gains and might even manage to push Isis out of Mosul.

The bad news, however, is that if Isis loses ground in its heartland, it will have more incentive to strike back with terror attacks in Europe. The opening days of 2016 have already seen alerts in Munich and Amsterdam. The threat of terrorism is, sadly, one area where I think it is safe to bet on continuity in the coming year.

Review & Outlook

Who Lost the Saudis?

Iran and Russia have an interest in toppling the House of Saud.

Saudi King Salman bin Abdulaziz    
Saudi King Salman bin Abdulaziz Photo: Agence France-Presse/Getty Images

That headline question may seem premature, but it’s worth asking if only to reduce the odds that the Saudis are lost as we enter the last perilous year of the Obama Presidency. Iran and Russia have an interest in toppling the House of Saud, and they may be calculating whether President Obama would do anything to stop them.

This comes to mind watching the furious reaction by Iran and its allies to Saudi Arabia’s New Year execution of 47 men for terrorism. Most of the condemned were Sunnis, including members of al Qaeda, but the Saudis also executed prominent Shiite cleric Nemer al-Nemer, who had led a Shiite uprising in 2011.

“The divine hand of revenge will come back on the tyrants who took his life,” said Iran’s Supreme Leader Ayatollah Ali Khamenei on Sunday, among many other denunciations across the Shiite Middle East. Protesters ransacked and set fire to the Saudi Embassy in Tehran before police belatedly stopped them. The Saudis responded by cutting off diplomatic relations with Iran.

Nouri al-Maliki, the Iranian ally and former Prime Minister of Iraq, put regime change on the table by saying the execution “will topple the Saudi regime as the crime of executing the martyr al-Sadr did to Saddam” Hussein. He was referring to the death of another prominent Shiite cleric in Iraq in 1980.

Iran already has ample reason to want to topple the Saudis, who are its main antagonist in the Shiite vs. Sunni conflict that has swept the region amid America’s retreat. The two are fighting a proxy war in Yemen, after a Saudi-led coalition intervened to stop a takeover by Iran’s Houthi allies. The Saudis are also the leading supporter of the non-Islamic State Sunnis who are fighting Syria’s ally Bashar Assad. Russia and Iran are allied with Assad.

Then there’s Saudi oil production keeping oil prices low. As the biggest exporters in OPEC, the Saudis have refused to cut production to stem a supply glut that has cut prices to $37 a barrel.

This means Iran will get much less benefit from its renewed ability to export oil under its nuclear accord with Mr. Obama.

Saudi exports are also punishing Russia, the world’s second largest oil producer, which by some accounts needs oil at $100 a barrel to satisfy Vladimir Putin’s domestic promises. The ruble dropped to its lowest level to the dollar in 2015 last week on the prospect of still-lower oil prices. Russia and Iran would benefit greatly from internal Saudi turmoil or the threat of a larger regional war that caused oil prices to spike.

None of this means a direct Iran-Saudi conflict is imminent, though with dictatorships you never know. Iran had no good reason to fire rockets within 1,500 yards of the USS Truman last month, but it may have been testing to see how the U.S. would react. The Administration didn’t respond until the news was leaked, and then with a mild military statement.

The White House decision last week to walk back U.S. sanctions against Iran after its recent ballistic-missile tests may also embolden Iran to take greater risks. Iran’s leaders may believe the nuclear deal is a greater restraint on the U.S. than on their own regional ambitions. They can always threaten to leave the nuclear deal if the U.S. imposes new sanctions. The Revolutionary Guard may also believe they have more freedom of action given Russia’s support in Syria and its plan to deliver S-300 anti-aircraft missiles.

As for the Saudis, they can be forgiven for doubting that they can count on President Obama.

Fairly or not, they concluded from the fall of Egypt’s Hosni Mubarak that this Administration will abandon its friends in a pinch. They saw his “red-line” reversal in 2013 in Syria, Mr. Obama’s accommodation to Russian revanchism in Crimea, and that he now may let Assad keep power in Syria. The Saudis intervened in Bahrain in 2011 without telling the U.S., and they recently formed a new Sunni-state coalition to fight Islamic State—again without the U.S.

The Saudis treat domestic dissenters harshly, but the Shiite cleric Nemer was no human-rights activist. Joseph Braude of the Foreign Policy Research Institute says that in the 1980s and 1990s Nemer was a leader in Hezbollah al-Hejaz, an armed group in Saudi Arabia’s eastern province. Nemer followed the teachings of Iran’s Ayatollah Khomeini and declared the Sunni ruling dynasties in Saudi Arabia, Bahrain and Kuwait to be illegitimate. While he later toned down his revolutionary rhetoric, by 2009 he was again advocating a military option.


The Saudis are often difficult allies, especially the support by rich Wahhabi sheikhs for radical Islamist mosques and schools around the world. But in a Middle East wracked by civil wars, political upheaval and Iranian imperialism, the Saudis are the best friend we have in the Arabian peninsula.

The U.S. should make clear to Iran and Russia that it will defend the Kingdom from Iranian attempts to destabilize or invade.

Are Governments Running Out of Candy?

by Jeff Thomas

By now, many readers will have seen the popular American YouTube video by Mark Dice in which he stands on a city sidewalk and offers passers-by a free gift. They may choose between a 10-ounce silver bar or a large Hershey’s candy bar.

Each taker chooses the candy - most of them with no deliberation. The only taker who seems to hesitate at all soon decides on the candy, as “I don’t have any way to do anything with the silver.” (Behind them is a coin shop. Mister Dice offers to take the silver bar inside if she wishes, but she’s uninterested and takes the candy.)

A 10-ounce silver bar is presently valued at about $140, the Hershey’s bar at about $2.
(Editor’s Note: If you have not seen the video, please see below.)

Mister Dice doesn’t comment in the video as to what lesson might be learned from this, but an obvious one would be that Americans (or at least those who reside in his home town of San Diego, California) are prone to prefer instant gratification over something of substantially greater, but delayed value.

If this is his intent, he’s succeeded well in his light-hearted, but instructive video.

Since the 1950’s, much of the world has perceived Americans as being on “Easy Street,” and in recent decades, the U.S. government has fuelled American complacency through a consciousness of easy money and entitlement.

And so, Americans are often perceived by those outside the U.S. as being somewhat insulated, spoiled, naïve, and short-sighted. But, if this is true, Americans certainly aren’t alone. Much the same exists in Europe, Canada, and quite a few other countries that have, over recent decades, followed the American socio-economic model.

Trouble is, all that easy money and entitlement exists only as long as a source for the “freebies” exists. Unfortunately, the idea that freebies are free is inaccurate. Freebies of any description must be paid for by someone.

In business, freebies are sometimes provided as “loss-leaders” to attract more business. They therefore become a line item on the monthly balance sheet, a cost-of-doing-business expense. The business hopes to make the loss back through sales generated by the loss-leader.

But, when governments hand out freebies, no sales will be generated, so the loss will not be recovered. When governments hand out freebies, the cost is paid with tax revenues. And when taxes have been raised to the point that further increases would be difficult without inciting rebellion, governments generally rely on borrowing.

But, of course, borrowing, too, eventually reaches the point that it has become so great that it cannot be repaid. What then?

Invariably, economic collapse is the outcome. But, why should this be so? Well, when the tipping point is reached (as in jurisdictions like the EU and U.S., where more than 50% of the public are net recipients and the other 50% must pay for both themselves and the other 50%), there’s no turning back. Those who have been receiving the candy have been told that they’re entitled to it and now they believe it. They will not tolerate the suggestion that the freebies must end, even though no further tax can be reasonably levied; no further funds can be borrowed. Therefore, in every case, the result is systemic collapse, not a gradual tapering off.

For thousands of years, governments have sought to appease people with freebies. In ancient Rome, a dole of grain and free entertainment (bread and circuses) helped to usher in the decline of the empire.

Like all great empires, it collapsed under a weight of debt and mismanagement.

Much of the world is presently at this tipping point. Governments continue to promise benefits that they know will soon come to an end. If history repeats, they will continue repeating this promise right up until the day when the candy stops being dished out.

They will then say that no one could have seen this coming.

Amongst the public who will be the victims, there will be three general groups. First will be the Takers, those who have been the recipients who depended upon the freebies the most. They will be the hardest hit, as not only will they lose the freebies, they will have neither the skills nor the imagination to become self-reliant overnight.

The second group will be the Payers, those whose tax dollars paid for the freebies. They will be hard hit, as the system in which they live and operate has broken down, although they will fare better than the Takers. They will have the skills and imagination to rebuild their lives (having previously been productive enough to pay for themselves and others.)

Third will be the Preparers, those who envisioned the inevitability of the collapse of the system. They most certainly will have the skills and imagination to rebuild their lives, but, additionally, they’ll have the means with which to rebuild quickly. They will be the very few who chose the silver bar over the candy and had the wisdom to store the silver in a jurisdiction where it was not likely to be appropriated by a dying empire.

Much of the world is now running out of candy. The latest version of Bread and Circuses is reaching its inevitable end.

Replaying the video, we observe Mister Dice offering chocolate or silver. Each Taker looks at him incredulously, then makes the obvious choice, the candy. Each of them gives him a smile. Each is pleased to walk away with the chocolate, but, likely as not, each will have consumed the bar before the day is out and the benefit of the freebie will be short-lived.

After giving out eight bars, Mister Dice is all out of chocolate and he presumably goes home. He has no candy, but he does have 10 ounces of silver. Perhaps he owns other silver bars as well, stored in a safer jurisdiction.

Each of us has the opportunity to make a choice as to whether we wish to be Takers, Payers, or Preparers. The choice we make may define our future.

Editor’s Note: The U.S. government’s bad financial decisions and massive debt levels will cause another financial crisis sooner rather than later.

Like most governments that get into financial trouble, we think American politicians will keep choosing the easy option…money printing on a massive scale.

This has tremendous implications for your financial security. These politicians are playing with fire and inviting a currency catastrophe.

This is a big reason why we think everyone should own some physical gold and silver. Precious metals are the ultimate form of wealth insurance. They have preserved wealth through every kind of crisis imaginable. They will preserve wealth during the next crisis, too.

But, if you want to be truly “crisis-proof”, there is more to do...

Most people have no idea what really happens when a currency collapses, let alone how to prepare…

How will you protect your savings in the event of a currency crisis? This just-released video will show you exactly how. Click here to watch it now.


The coming confrontation

A dangerous stand-off looms between the government and the newly elected parliament

IT WAS rowdy and disorganised. At one point it nearly degenerated into a brawl. But the opening on January 5th of Venezuela’s parliament, the first to be elected with an opposition majority in 17 years of autocratic rule, had the feel of a velvet revolution. The portraits of the late Hugo Chávez, the founder of the populist movement that still governs the country, and Simón Bolívar, the 19th-century liberator whom the chavistas claimed as inspiration, had been taken down. Speeches by opposition deputies, once routinely cut short by the bullying former president of the National Assembly, Diosdado Cabello, were heard in full. Dozens of police guards around the building leaned into their car radios to hear politicians rail against the authoritarian and incompetent rule of the current president, Nicolás Maduro. “This is a wake-up call,” said a soldier as he listened raptly to the proceedings. 

The chavistas did not put up with the harangues for long. After less than an hour they walked out—in protest at supposed procedural errors by the new president of the assembly, Henry Ramos. Even then they could not escape interrogation. Parliament’s new masters had opened its doors to all journalists, not just pro-government ones as before. The normally cocky Mr Cabello, who led the walkout, looked distinctly uncomfortable when confronted by reporters who asked mildly testing questions on live television. Cilia Flores, Venezuela’s first lady, who is one of 54 chavistas in parliament, icily refused to answer one about two nephews who are facing narcotics charges in the United States. 

Chavismo has been wounded, but it is far from defeated. Parliament aside, all the main institutions of government remain under its control. The setback to the regime has made it more authoritarian.

Before parliament’s opening Venezuela’s Supreme Court had ruled that four of the incoming MPs from the state of Amazonas, three of them from the opposition Democratic Unity alliance (MUD), could not be sworn in. They are the subjects of investigations into possible electoral fraud. This ruling threw into doubt the two-thirds majority the MUD appeared to win in the election on December 6th. Such a “supermajority” would allow the opposition to begin the process of appointing and dismissing Supreme Court judges and to convene a convention to rewrite the constitution. The day after its opening parliament defiantly swore in the three MUD deputies, restoring the opposition’s two-thirds majority.

Supreme weapon
In the battle that now looms with parliament, the Supreme Court may become the regime’s main weapon. One of the last acts of the outgoing assembly was to stuff the court with 13 new pro-government judges. Mr Maduro has already suggested that all legislation that he disagrees with, including a proposed amnesty to secure the release of scores of political prisoners, will be deemed unconstitutional by the Supreme Court. “It is difficult to imagine that congress can have an institutional conflict against the Supreme Court and win,” says Luis Vicente León, a pollster. 

The government may hope to provoke divisions within the MUD. Its representatives in the National Assembly are from a hotchpotch of 13 parties, united in their desire to defeat chavismo but often divided over the best means to do so. Mr Ramos, a cantankerous veteran from the Democratic Action party, which governed Venezuela before Chávez, was the choice of smaller parties within the MUD.

They fear domination by the younger Justice First party, led by Henrique Capriles, who nearly won a presidential election in 2013.

Mr Ramos is himself a divisive figure. Ahead of parliament’s opening session he confirmed that he would seek the constitutional removal of Mr Maduro from the presidency within six months, presumably by launching a referendum to recall him from office. Moderates in the coalition have resisted issuing such a clear challenge to the executive so soon.

Time is working against the regime. The price of Venezuela’s heavy oil, virtually its only export, dipped to under $30 a barrel in December, its lowest since February 2004. Default on some of its $98 billion of foreign debt is “becoming hard to avoid,” says Barclays Bank. Over 2015 and 2016 the economy is likely to shrink by nearly 15%. Shortages of basic consumer goods will get worse. In the absence of official figures, analysts reckon that inflation is nearly 200%, the highest rate in the world.

A decree by Mr Maduro, enacted before the new parliament opened, shows that the regime has little intention of doing anything new about the dire state of the economy. It strips the assembly of its right to appoint directors of the Central Bank, or even to question them.

As the confrontation between president and parliament worsens, Venezuelans wonder what role the army will play. On the night of the parliamentary election in December, the country’s defence minister, Vladimir Padrino López, declared in an unscheduled appearance on state television that the army would “uphold the constitution”. Some analysts saw that as a warning to government hardliners to accept the results. The night before parliament opened, General Padrino López went public again.

“The Bolivarian Armed Forces is not a means to subvert the constitutional order,” he tweeted, somewhat cryptically.

The government’s eccentric claims about what is constitutional put the armed forces in an awkward position. “The military says it is going to defend the law, but what is the law?” wonders Mr León. Venezuela’s looming struggle is largely about the answer to that question.

Dangerous Escalation In Currency Wars - Next Move U.S. Treasury

by: Tim Clayton


- Global currency wars are liable to escalate over the next few months as China devalues.

- Without international co-operation, there will be growing domestic demands for US trade retaliation and a weaker dollar.

- The US currency is liable to weaken sharply from any move to near parity against the Euro.

Global central banks outside the US will be under sustained domestic pressure to boost growth through aggressive monetary policies, but this policy will increase the risk of globally crippling trade wars as the US Treasury and Congress will be under intense pressure to respond with sanctions if the dollar continues to appreciate. The Federal Reserve will be boxed in and find it increasingly difficult to curb domestic excesses with higher interest rates. In this environment, there will be growing pressure for dollar strength to be curbed either through multilateral co-operation or unilateral US Treasury intervention. Risk/reward for holding long dollar positions against European currencies will be increasingly unattractive.
The latest US manufacturing PMI release registered the second successive reading below 50.0 and the lowest since Mid 2009. Surprisingly, the export component actually registered a figure above 50 which suggests an expansion in overseas trade, but the overall export performance has been lackluster at best with November goods exports the lowest level for over three years and there will be growing concerns surrounding the US manufacturing sector. Although competitiveness has certainly been improved over the past few years by falling energy costs, this is being undermined by a stronger dollar and the US economy is not immune to the strong-currency impact.
There has also been further evidence of an escalation in currency wars over the past few weeks.
Late in 2015, the Chinese central bank effectively switched to targeting a stable yuan against a trade-weighted basket of currencies rather than against the US dollar, a clear signal that the PBOC was looking to weaken the yuan against the dollar and the Chinese currency has moved to five-month lows against the US currency.

The ECB has pursued an aggressive monetary policy, in part to push the Euro weaker in an attempt to ease imported deflationary pressures. This week, the Swedish Riksbank indicated that it was now willing to intervene in the market at any time to weaken the krona against the euro. The Bank of England was effectively forced to rule out a first-quarter increase in interest rates due to lower inflation forecasts and Sterling strength against the euro.
Although the Bank of Japan has been expressing greater confidence surrounding the inflation outlook and looking to declare victory in the battle against deflation, the stronger yen and lower energy prices will trigger a fresh decline in consumer prices over the next few months with the bank back to square one. Japan is also losing competitiveness in regional markets once again as the yuan weakens. There will be growing pressure on the Bank of Japan to sanction another boost to the quantitative easing program.
With the Federal Reserve raising interest rates in December and expecting to tighten further during 2016, the dollar has pushed higher once again with a fresh advance against European currencies. The yen has also strengthened against all major currencies at the start of 2016. The Federal Reserve and Treasury are likely to be increasingly uneasy over the implications of a stronger dollar, especially given the pace of gains seen during the past 12 months.
It can be argued that the stronger dollar will have a beneficial impact as it will tend to limit the scope for Federal Reserve interest-rate increases. There is, however, a major problem in that US economic growth is being supported by internal demand and there is a strong case that interest rates are too low for the domestic economy. There is a growing risk of destabilizing domestic bubbles and accelerating inflationary pressures within sectors not exposed to international competition.
The Federal Reserve will either have to set interest rates too low for the domestic economy in order to curb further dollar strength or it will have to push rates higher and risk a serious contraction in the manufacturing sector.

Politically, this issue will also become increasingly sensitive in a presidential election year.

There will certainly be strong congressional pressure for more aggressive trade action including, for example, retaliatory action and anti-dumping tariffs on China. Trade policy would also be a key element in the presidential campaign and protectionist rhetoric would intensify. Any move to parity against the Euro could be a breaking point for US officials, at a minimum US rhetoric would become more aggressive with verbal intervention. The last thing the global economy needs in the current cycle is an escalation in trade wars and international co-operation is needed to avert these risks.
A further strengthening of the dollar will also increase debt-servicing costs in dollar-denominated loans which will cause further stresses within emerging economies. This will tend to negate the potential beneficial impact in the form of lower debt interest costs, especially as bond yields would eventually rise in the face of increased domestic inflationary risks.