Since the Fed first indicated that it was prepared to provide additional support for the U.S. economy on August 27, the U.S. dollar index has dropped 6.5 percent (Figure 1). Funds have been flowing out of U.S. dollars on fears that quantitative easing (QE) will eventually lead to a sharp rise in inflation and act as a de-facto USD devaluation. Due to the uncertainties of quantitative easing implementation, and to a greater extent its removal, these are valid concerns. However, given the U.S. dollar's performance throughout the first round of QE, the uncertain macroeconomic outlook in other major developed economies, as well as the well vocalized distaste for appreciating currencies in the emerging markets, there is reason to believe that recent dollar weakness may be overdone.
FIGURE 1
An important caveat to the quantitative easing program is that there is no real evidence to suggest what amount of asset purchases are required to achieve a given reduction in interest rates and, by extension, what effect those lower rates will ultimately have on the real economy. As the Fed prints more money to purchase bonds and drive down interest rates, the chance of overshooting the "target" and sparking inflation becomes greater. This lack of transparency makes the implementation and removal of quantitative easing difficult to orchestrate. It becomes even more challenging if one considers that the target that Fed is aiming for may have shifted, due to changes in the underlying structure of the economy.
Structural Changes
Any possible change to the underlying structure of the economy would be largely a function of the unique post-crisis debt hangover that the U.S. is experiencing. As consumers retrench and repair their balance sheets, they are reluctant to spend and remain focused on paying down debt. Employers, meanwhile, are unlikely to hire additional staff in light of this decreased demand environment. Indeed, long-term unemployment in the U.S. has reached record levels (Figure 2). As these workers remain out of the labor force for increasing periods of time, their skills erode making them less employable and more likely to find themselves in lower paying positions when they eventually return to work. At the same time, the housing bust has removed one of the key pillars of strength for the U.S. labor force: labor mobility. Individuals who owe more than their home is worth are less likely to change locations in search of better employment opportunities elsewhere.
While contested by the Federal Reserve, the IMF has estimated that structural changes such as these in the U.S. economy may have increased the natural rate of unemployment from 5 percent to 6.0 - 6.75 percent. If correct, this assumption implies that there is a significant portion of joblessness that will remain unresponsive to additional stimulus or changes in demand. By extension, we may hypothesize that if the Fed were to reference an outdated, lower natural rate of unemployment when conducting its quantitative easing policy to resuscitate demand in the economy, the result could be higher inflation accompanied by little — or no — change in actual joblessness.
FIGURE 2
Inflationary Factors
Before we run for the inflationary hills, however, it is worth noting that since 2008 the Fed has already expanded its balance sheet dramatically, purchasing $1.75 trillion in government bonds and mortgage-backed debt (Figure 3). During this time, long-term bond yields have indeed declined markedly, yet growth remains sluggish and inflation, at 0.8 percent, remains well below the Fed's comfort zone of 1.7 – 2.0 percent. Given these results, it is difficult to accurately assess the effectiveness of the first round of quantitative easing. The net change in the value of the USD over this period of time, however, was a relatively modest decline of 6.25 percent. As reported by the Financial Times, this change is roughly in line with research conducted by the Federal Reserve in 1999 that suggests a policy change reducing 10-year yields by 50 basis points would result in a 5 percent decline in the value of the dollar.
FIGURE 3
To date, the dollar has already declined 6.5 percent since the Fed's first mention of QE on August 27, and inflation expectations are creeping bank into the Fed's target zone (Figure 4). As such, it appears that the Fed has been successful in altering inflation expectations to some extent by simply clearly communicating its intentions to the market. However, while the Fed can easily jaw bone the markets, flood the economy with cash and push down interest rates, it has no ability to directly force banks to lend, businesses to borrow or consumers to spend. The Bank of Japan, for example, has had very little impact on growth, inflation and unemployment despite a massive monetary stimulus and quantitative easing program. While there are key differences between the U.S. and Japan in terms of policy response time and intensity, the common denominator that both countries face is a simple, yet frustrating, lack of domestic demand.
FIGURE 4
Alternatives to the Dollar
Against this uncertain backdrop in the U.S., there are few attractive alternatives in the developed economies for those fleeing the U.S. dollar. For example, after years of stimulus and its own tangle with quantitative easing, interest rates in Japan remain at rock bottom levels while the U.K. — no stranger to quantitative easing itself — has recently announced a wrenching fiscal retrenchment package that will likely weigh on growth in the future. By default, funds in the developed world have been flowing into the euro zone as the ECB — ever the inflation hawk — remains focused on removing additional monetary support measures for the economy. Meanwhile, simmering just below the surface, we see many of the same sovereign structural issues that plagued the euro zone just five short months ago. To say nothing of the cries from German exporters, one of the few growth engines in the euro zone, about the current level of the euro.
Likewise, hot money flows into the emerging markets, a relative oasis of high interest rates and growth potential, have sparked heated talk of a "currency war." While nations such as Thailand and Brazil have already introduced taxes on foreign holdings of government bonds, many speculate that emerging economies may impose additional broad-based capital controls to further discourage assets fleeing the low rate environment of the U.S. and developed world.
With the outlook for the U.S. economy unclear, the dubious implications of quantitative easing and the enticing yields in the emerging markets, there appears to be a nearly universal distaste for holding dollars. However, while real inflationary risks remain in the longer term due to the Fed's unconventional policy approach, given the uncertainties regarding the responsiveness of the economy to quantitative easing, the lack of attractive alternatives in the developed world and the dollar's performance throughout the first round of QE, the U.S. dollar is looking increasingly oversold in the short to medium term.
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