Sunday, June 8, 2008

Intervention bluffs

This was the kind of week that gets economists ecstatic. Yeah yeah, we had Hillary conceding (yawn)… or “Sex and the City—The Movie” breaking records at the box office, trouncing even “Indiana Jones” (horror!). But no, it wasn’t a bunch of female celebs that got economists on their toes. Instead, it was two austere gentlemen in dark suits.

First, it was Ben on Tuesday:

“We are attentive to the implications of [a weak] dollar for inflation and inflation expectations…. and will continue to formulate policy to guard against risks to both parts of our dual mandate...”

Fed-speak decipherers interpreted the statement as “verbal intervention:” A “woof” aiming at talking up the dollar with words but no actions (such as raising interest rates while the housing market remains in freefall). But hey, interest rates might not be the only weapon, right? So some started wondering: “Could Bernanke be ready to take real action? Like… have the Fed buy dollars to support the currency from falling more?

So no sooner than Ben woofed, the (dollar) bears ran away and the dollar staged an impressive rally…

…till Thursday. That was the turn of another gentleman, the (French) President of the European Central Bank (or ECB), Jean-Claude Trichet. Only Trichet did not woof, he roared, effectively preparing the ground for a “possible” increase in the euro-area’s interest rates at the ECB’s next meeting to stop inflation from rising. And so the dollar bears came back with a vengeance, sending the euro back up towards 1.58.

So much for Ben’s verbal intervention. Or shall we call it “cheap talk”? Because it’s hard to see how intervention would work to bring the dollar up... and it’s even harder to think that Ben doesn’t know this already!

Successful interventions: Many a Central Bank have attempted to influence their currency by intervening in the foreign exchange market. The channels through which such an intervention might work were very nicely explained in the recent issue of the IMF’s Finance & Development magazine so I won’t repeat the experts. I’ll go straight to the conclusion: Intervention to support the dollar wouldn’t work this time!

Sterilized intervention: First, let’s look at the so-called “sterilized intervention” approach: On one hand, the Fed would sell its foreign currency holdings to buy dollars. But the sale would now reduce the money supply. So the Fed would also buy an equivalent amount of US Treasuries (thus putting money back into the market) to make sure money supply stays the same. What the Fed would hope to achieve in the process would be to lower the risk premium on the US Treasuries (by reducing their supply). This would effectively make them look less risky, increasing their demand, and prompting a mini-return to dollar-denominated asset.

Problem is, in the US—as in most advanced economies—the size of the intervention would typically be way too small compared to the outstanding stock of government bonds to have a meaningful impact on their risk premium (and, thus, on the exchange rate).

Providing the “mo”: So let’s look at what the IMF article calls the “microstructure channel”: It is perfectly possible that some market players are on standby to buy the dollar, yet they don’t do it out of fear the Fed is still too focused on growth and too nonchalant on inflation. So if the Fed were to talk tough on inflation and the dollar, couldn’t it provide the necessary “mo” to start a snowball of "buy-dollar" trades? Conceivable, yet not sustainable, unless economic fundamentals become more supportive. It’s for the same reason why the “signaling channel” mentioned in the article would not work.

Then and now: To illustrate this last point… Remember that February in 1987, the time of the Louvre Agreement to boost the dollar? Well, if you take a look at how the dollar moved after that, you’ll see it practically continued to go downhill for another… eight years! The reason? America’s economic fundamentals were not compatible with a stronger dollar.

Fast forward to 2008. First, you have a US trade deficit that remains pretty spectacular by historic standards. This means America will need to continue to attract enormous amounts of money from abroad to finance its consumption and investment needs.

But US interest rates are very low (translate: "unattractive") compared to every other advanced economy but Japan. And low they will remain, as much as Ben would like to feign an actionable concern about inflation. Jobs are still being lost, house inventories are near historic peaks, house prices are plummeting, the mood in the banking sector is still fairly grim.

Lower US interest rates than elsewhere imply a cost for those wishing to invest in low-yielding US Treasuries and forego higher returns on, say, the euro or more “exotic” currencies such as the Norwegian krone. So (private sector) demand for US dollars should remain hesitant.

True, foreigners might be attracted by the fact that, eventually(!), the dollar is bound to appreciate again. Indeed, by some measures of “fair value” (such as the purchasing power parity) the dollar looks undervalued. But deviations from “fair value” only signal long-term movements (long as in “can take years”) and, in the meantime, those who dare might end up paying a price.

Intervention already, all over: Just in case it escaped you, a (massive) intervention to support the dollar has been happening for years now. No, not by the Fed, but by the so-called "emerging markets"—the likes of China, Russia, Saudi Arabia, to mention a few. US Treasury data show that, in the first quarter of 2008 alone, accumulation of US assets (debt or equities) by foreign governments stood at almost $110 billion (a figure that, as some analysts point out, likely underestimates the full amount). That’s $50 million each hour! So I’d like to see how effective Ben & co. would be in helping the dollar, over and above the colossal help extended already.

The drama: So what was Ben’s woof about? Are there any scenaria in which he might actually step in with some real cash? Let’s see…

A fresh spike of oil prices? Well, so much for that. Oil prices hit $139 a barrel on Friday, and there was no Fed to stop them.

Another collapse of a major bank (let’s say Lehmans, for example’s sake)? Tough to see how Ben could stop a massive exit from the dollar as risk premia go through the roof.

An exasperated Trichet threatening Ben at gunpoint to do “quelque chose” about the dollar? An entertaining thought… and maybe (maybe) the kind of drama that would make the Ben & Jean-Claude duo beat “Indiana Jones” at the box office!

Glossary: Foreign exchange intervention, verbal intervention, sterilized intervention, purchasing power parity, risk premium, Indiana Jones, quelque chose (=”something” in French).

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