Thursday, November 15, 2007
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]
In the wake of the Fed's 0.75% easing over the past couple of months and the subsequent collapse of the US dollar, Macro Man has been giving thought to the notion that the fundamental construct of US monetary policy is inherently disadvantageous to foreign holders of dollar-denominated assets, and that the apotheosis of this long-term trend may be upon us. He briefly sketches out these thoughts below, and welcomes reader comments.
The Federal Reserve Acts of 1913 and 1977 laid out the policy objectives of the Federal Reserve System. The text of the latter Act, quoted above, spelled out in specific terms what has become known as the Fed's "dual mandate": namely, to promote maximum employment and low inflation. Of course, taken literally, one could argue that there is in fact a triple mandate, with asset-price targeting in the bond market as the third leg of the policy tripod.
Now, whether one assumes a dual or a triple mandate, it is clear that the Fed's policy objectives differ from those of most other major central banks. The Bank of England, for example, has a specific CPI target of 2% over a two year horizon. The ECB has a "primary objective of price stability", which the ECB has chosen to define in its own fashion. There is a secondary objective of supporting the economic goals of the EU (maximum employment and stable non-inflationary growth), but price stability takes primacy. The RBNZ has an explicit policy target of keeping future CPI inflation between 1% and 3%.
The difference here should be clear. Banks like the ECB, BOE, RBNZ, and others have an explicit primary policy target of price stability. That comes first and foremost. The Fed, on the other hand, must balance its focus on price stability, which it shares with other CBs, with an explicit focus on supporting economic activity so as to reach its equally important goal of maximizing employment.
Now many commentators, including Macro Man, have given Alan Greenspan and Ben Bernanke a lot of stick for being serial bubble blowers. But perhaps some of that criticism is misplaced. Perhaps where we should really direct our ire is the Federal Reserve Act itself, which essentially directs the Fed to ignore the inflationary consequences of its actions if it judges those consequences to be less severe in relation to its policy goals than a potential loss of employment. What Macro Man is saying here is that there is no such thing as a "Greenspan put" or a "Bernanke put"; what it is is a "Federal Reserve Act put."
When you think about it, the practical implications of this policy structure are quite significant. The Fed's dual mandate essentially carries with it an implicit promise that Fed policy will be more "dilutive" (to borrow a term from occasional poster Mencius Moldbug) than policy in most other developed economies. While this is not necessarily a bad thing for US residents, for whom maximum employment, broadly stable prices, and moderate long-term interest rates are surely worthy goals, it is a decidedly unpleasant outcome for non-resident holders of US dollar assets.
Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.
It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc.
Policymakers in these countries are finally becoming aware of this, with the UAE the latest country to suggest a change to its dollar peg- and not before time. Private investors evidently knew the score a year or two ago, which has resulted in a buyer's strike of US dollar-denominated financial assets, leaving the mercantilists and the oil producers holding the bag.
So where to go from here? Unless something changes, it is very difficult indeed to see private sector investors step in to buy dollar assets unless they are allowed to get cheaper (either in dollar terms or via a much lower dollar.) That having been said, a couple of caveats.
The Fed took a small step, in Macro Man's opinion, towards recovering an element of credibility by suggesting yesterday that their medium-term price target is headline, rather than core, inflation. By starting to forecast headline inflation (which necessitates that they pay attention to it), investors can derive at least a modicum of satisfaction that they may not be completely sacrificed at the altar of ex-food and energy.
Moreover, the currencies that have heretofore carried the load in strengthening against the dollar are starting to develop some serious warts. Yesterday's UK inflation report hinted at a significant downturn in growth even if the BOE cuts rates. Unusually, Mervyn King noted that currency tensions will be discussed at this weekend's G20 meeting in Cape Town. EMU monetary conditions are the tightest in 15 years, and surveys are suggesting an imminent downturn. Canada's leading indicator posted its lowest reading in several years yesterday, and BOC deputy governor Jenkins has complained about the strength of the loony recently.
What it all means is that we may be rapidly approaching that Minsky moment when dollar-peggers have to change policy. At that point, we could actually see currencies like the euro and sterling decline against the buck, with dollar weakness manifesting itself most against erstwhile peggers. For the time being, reserve diversification flows should keep the euro broadly supported for the next month and a half, but Macro Man is now entering profit-taking mode on his euro long.
Ultimately, what we are witnessing is a second Nixon shock played out in slow motion. And the Fed's dual mandate ensures that John Connally's remark from 1971 holds true today: "the dollar is our currency, but your problem."