The interesting financial news this week besides Irish debt was the market and economists' outspoken criticism of the Fed's quantitative easing — the Fed's tactic to liven up the U.S. economy.
Given the interconnectedness of today's global economy, when the U.S. introduced more liquidity into our financial system by the Federal Reserve buying 5- to 10-year Treasuries, it did not mean that money would remain in the U.S. With the dollar's value under threat due to too many dollars floating around, it is only natural for the carry trade (borrowing a low yield currency to invest in a higher yielding currency) to take place to some extent.
Dollars that are put into the U.S. system are free to migrate anywhere. In this case, I would submit that the reason the Australian dollar strengthened over 15 percent since the beginning of July and accelerated from 0.9680 on October 29 to 1.0175 on November 4 (even though the Fed's announcement was on November 3) is that the market nearly always positions itself to take advantage of what will happen before the news is known. This is called front running. This leads to the phrase "buy the rumor sell the fact." The markets positioned themselves to take advantage that funds would flow into Australian dollars not only because the expected Fed announcement would devalue the dollar, but also the Australian central bank (the Reserve Bank of Australia or RBA) would likely raise interest rates at their meeting on November the 3. It raised them from 4.5 percent to 4.75 percent. This set up the traders with the opportunity to sell into the rising currency, which would have plentiful bids due to both the actions of the RBA and the Fed, enabling the traders to unload the significant long balances they had built up the week before. Sure enough, the Australian dollar fell to a low of 0.9725 on November 16.
Notwithstanding short-term speculative moves like this, which is a good example of the strategies that traders use given the low funding costs made available to banks because of quantitative easing, I don't think the Fed has any plans to put any restrictions in place to stop the outflows! So it will continue, unless there is a higher return opportunity domestically.
Back to the main subject. Global cash flows are important and what happens in one country can in exceptional circumstances affect almost all the other countries. The Fed made more dollars available via increased liquidity. The bond market criticized this action, raising interest rates by selling off Treasuries because of their view that all this money floating around would cause inflation. Inflation would come from the increased cost of imported commodities that have gone up in price, in U.S. dollar terms, due to the devaluation of the dollar. Like commodities, currencies should go up in value against the dollar as well, unless something like the Irish debt issue comes up and cause a short-term reversal in direction, but the longer-term weaker dollar trend.
When the Fed takes this kind of action it also has the same effect on the price of basic raw materials to any other currency that is pegged to the dollar.
This puts China in the position that unless it lets the yuan strengthen, the price goes up for the commodities it buys to make the goods it sells to the rest of the world. For this reason as input prices rise the prices of the finished goods that China sells rise, unless the Chinese absorb the increase in cost and they cannot do that as the margins are too small. The net result is that goods in dollar terms will cost more all over the world. The offset to this is that if the currencies like the euro go up in value with the commodity prices, they will not cost more. However, currency values do not normally go up as fast as commodity prices. In an event like the Irish debt crisis of last week, the euro lost value even against the dollar. Add this move to an increase in the cost of the finished goods it buys during this period from China, and you have a nasty case of double secret inflation!!
Again, notwithstanding the blip, the Fed's action causes a ramp higher in inflation globally in dollar terms. A smaller rise in other currency terms like the euro and the pound has little effect on the currencies that are principally sellers of commodities: Australia, New Zealand, Canada, South Africa, Russia and Brazil.
The result of what happened last week was that a think tank of Chinese advisors said that China needs to consider letting the yuan strengthen faster to offset the commodity import inflation I mentioned above. Last Thursday the People's Bank of China ordered a half percent increase in the reserve ratios that banks have to set aside against loans. Consumer prices rose at the fastest pace in two years recently. The Shanghai Composite Stock Index fell 3.2 percent this week on the outlook of further interest rate policy tightening, and the roll on effect of Mr. Bernanke's monetary easing continues.
Inflation does not cure deflation. If deflation is the Fed's target by printing money to create jobs, it had better consider that unless higher prices cause more demand for goods as people want to buy them before the prices go up, then without demand all the Fed will create is stagflation (i.e., inflation with no growth).
Unless a lot more Irish-type crises crop up (Portugal could be next and Greek problems are likely to arise again next year), the dollar should remain under pressure. China would do well to balance the rise in the yuan with the increase in commodity prices. In other words, let it speed up its revaluation against the dollar and the Fed chairman should get used to a follow-on barrage of criticism he received last week.
Monday, 11/22, update: Irish indebtedness contagion has again caused for the dollar to be sold off this morning. The Irish debt crisis is not a done deal yet.
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