The dollar has begun to weaken again after the Federal Reserve last month cut its interest rate target to zero and shifted more explicitly towards a policy of quantitative easing.
As the December Federal Open Market Committee meeting minutes show, America’s central bankers expect to keep interest rates super low for the foreseeable future while continuing to expand the Fed’s balance sheet.
At the same time US fiscal policy is also set to be loosened aggressively. The Obama administration’s likely stimulus package will push America’s budget deficit well above one trillion dollars this year.
Washington’s policymakers have little choice as they aim to prevent America’s economy tipping into depression. But they need to be aware of the risks to the dollar.
Zero interest rates, a contracting economy, a still large current account deficit and suspicious foreign investors are a potent combination that could lead to a rout of the greenback.
A dollar collapse is not inevitable. In order to keep investor confidence in America intact, US officials should take the following steps.
First, the Fed should make it clear it will not consider buying foreign assets as it undertakes quantitative easing. America’s central bank has already begun buying domestic mortgage backed securities. But purchasing foreign currency denominated assets would cause the dollar to fall sharply.
Second, Fed officials should stress that quantitative easing will be curtailed once it becomes clear America’s economy is stabilising. The signals in the latest FOMC minutes that the Fed will keep moving towards inflation targeting – implicitly if not explicitly – are welcome.
This will assuage concerns that US policymakers want to inflate their way out of recession, soaring fiscal deficits and record private sector debt. Ben Bernanke’s initial four year term expires in a year’s time. If President Obama doesn’t reappoint him, the Fed Chairman will want to leave a legacy that includes a more prominent role for inflation targeting in the setting of US monetary policy. That will benefit the dollar now.
Third, exchange rate policy in America is the responsibility of the US Treasury. Once they take office Tim Geithner and Larry Summers should both make a clear commitment to preserving the value of the greenback. After all, former Treasury Secretary Summers was one of the original advocates of the ‘strong dollar policy‘ in the 1990s.
Fourth, the new Obama administration must avoid the policy mistakes made during the early years of the last Democrat administration. President Clinton’s first Treasury Secretary, Lloyd Bentsen, decided to talk down the dollar against the yen to force Japan to open its markets more to American exports. Such crude protectionism now would quickly cause a run on the greenback in the current economic circumstances.
Last, America should re-assure its allies in Europe, the Middle East, Asia and Latin America that it does not seek to devalue the dollar. The G7 remains the obvious forum to keep the world’s wealthy democracies on side. If the dollar starts to slide precipitously this year, the G7 is likely to consider co-ordinated intervention in the currency markets.
This would be the first time for such action since the European Central Bank persuaded the Fed and the Banks of England, Canada and Japan to prop up the weak euro in September 2000. But the allies that really count here are not America’s G7 partners. Instead it is the large foreign exchange reserve holders of Saudi Arabia, UAE, Taiwan, South Korea and Singapore that shelter under America’s security umbrella. It is clearly not in these countries’ interests to see the currency of their principal military ally suffer an outright collapse.
These are some of the steps needed to prevent quantitative easing in America turning into a rout for the dollar. Fortunately for the greenback, US policymakers are not alone. Already Bank of Japan, Bank of England and Swiss National Bank officials have acknowledged the risks that their institutions will also shift towards quantitative easing as they cut interest rates towards zero. Once the ECB follows suit, there will once again be no major alternative to the dollar as the world’s reserve currency.
The writer is managing director of foreign exchange strategy at UBS Investment Bank
