Jan 14, 2005
Global: The Dollar Can?t Do It Alone
U.S.: Business Conditions -- Goldilocks? Not Quite?
Emerging Markets: No Fed, No Party?
Japan: The Post-Post Office Reform Agenda
Japan: Escaping Deflation - Expectations and Reality
Central Europe: Monetary Policy in Flux
Global: The Dollar Can?t Do It Alone
Stephen Roach (New York)
It wasn’t supposed to be this way. Global rebalancing appears to be stymied. Nearly three years into the dollar’s correction and the US trade gap keeps hitting new records. The external deficit on goods and services widened to a staggering $60 billion in November 2004. I’m old enough to remember when this would be a bad number for a year! This seemingly anomalous outcome reflects an important new shift in the macro fabric of the US economy -- a diminished sensitivity to currency fluctuations. That means it will probably take more than just a weaker dollar to spark global rebalancing.
The diminished sensitivity of the US economy to currency fluctuations has been increasingly evident over the past 15 years. Normally, a weakening currency results in a narrowing of a nation’s current account deficit and a pick-up in inflation. That’s pretty much what happened in the 1970s and especially in the late 1980s in the aftermath of the dollar’s sharp downward adjustment during most of that latter period. But then it all seemed to change in the 1990s. The dollar’s decline in the first half of that decade was accompanied by a shift in the current account from surplus back to deficit. And inflation barely budged. A similar outcome has been evident in the past three years -- a 16% decline in the broad dollar index (in real terms) accompanied by an ever-widening current-account deficit and persistently low inflation.
It’s not altogether clear why this relationship has broken down. My suspicion is that globalization is the main culprit. The globalization of supply chains biases import content to the upside for the high-cost developed world; it also forces the advanced economies to abdicate price setting at the margin to low-cost producers in the developing world. The result is a sharply diminished industrial base in countries like the United States. Manufacturing employment currently stands at only about 13% of America’s private nonfarm workforce -- down sharply from the nearly 23% share that prevailed in the mid-1980s, the last time the dollar entered a serious correction. Moreover, value-added in the US manufacturing sector fell to only about 14% in 1993-- down from 20% in 1985. The sharply diminished size of America’s industrial base makes it exceedingly difficult for the US to turn dollar depreciation into an advantage and trade its way out of a severe current-account problem through enhanced export growth and import substitution.
Nevertheless, the global rebalancing construct that I endorse still assigns an important role to a realignment of major foreign exchange rates. In my view, a lopsided world economy needs a shift in relative prices in order to establish a new and more balanced equilibrium. Currencies are nothing more than relative prices, essentially comparing the fundamentals of one economy versus another. With the dollar the dominant relative price in the world today, a depreciation of the greenback is necessary for global rebalancing. And, based on current account adjustments of the past, there’s good reason to believe that the broad dollar index has a good deal more to go on the downside. However, due to America’s reduced currency elasticities, a weaker dollar no longer appears to be a sufficient condition to complete the global rebalancing process.
If a weaker dollar can’t do the trick, what can? The answer, in my view, is real interest rates -- the price adjustment that could well qualify as the sufficient condition for America’s role in global rebalancing. The only way America can ever get a handle on its trade and current account conundrum is on the import side of the equation. After all, imports are currently 52% larger than exports (in real terms), making it almost mathematically impossible for the US to export its way out of its trade deficit.
Given the asset-dependent character of US domestic demand growth, the interest rate connection becomes all the more critical as an instrument of rebalancing. Higher real interest rates will not only curtail the pace of asset appreciation butwill also raise the cost of debt service -- thereby exerting twin pressures on the asset-driven portion of domestic demand. Needless to say, the saving-short, overly-indebted, and asset-dependent American consumer should feel the impacts of such an adjustment most acutely. But homebuilding will also be hit, as will business capital spending to a more limited extent.
So far, interest rates haven’t budged nearly enough to spark a meaningful rebalancing of a lopsided world. I suspect that the Federal Reserve is about to lead the way in changing that. The recently released December FOMC minutes reveal a Fed that may well be contemplating larger than expected interest rate hikes in the months and quarters ahead. The reason: The US central bank is now warning of a looming shift in its risk assessment -- expressing concerns over potential inflationary pressures and speculative activity in financial and property markets (see my 7 December dispatch, “Game Over?”). Unlike the case last year, when the debate was all about taking short rates up to the neutral threshold, a year later -- with the Fed voicing newfound concern over inflation -- the target may well have shifted into the restrictive zone. If that’s the case, then I still believe there is a good chance for the nominal federal funds rate to move into 4% to 5% zone by year-end 2005.
The Federal Reserve, of course, can only operate at the short end of the yield curve. The long end is a different matter altogether. Yet without an adjustment in long rates, progress on the rebalancing front could well continue to be disappointing. The outcome at the long end is likely be shaped by two competing forces: Yield pressures will be tipped to the downside if Fed tightening prompts a meaningful weakening in the real economy. But upside pressures could emerge if foreign investors start to diversify out of dollar-denominated assets and/ or demand to be compensated for taking additional currency risk. Barring a prompt and dramatic shortfall of real US economic activity, I believe that the upside pressures will predominate -- precisely the same outcome as in 1994, when a 300 basis point policy normalization was accompanied both by a back-up in long rates as well as by a sharp weakening of the dollar.
In looking at real US interest rates over the broad sweep of history, there’s nothing but upside from current levels. The real federal funds rate remains around “zero” and the real rate on a 10-year Treasury note is down to its post-1986 low of 0.7%. If the Fed steps up to the plate, as I suspect, and if Asian central banks finally start to diversify their foreign exchange reserve holdings, then real interest rates across the curve should move considerably higher. And that takes us back to the issue at hand -- global rebalancing. A weaker dollar has not been enough to spark this major adjustment in the world economy. It will take higher real interest rates to crimp the excesses of the asset-based component of consumer demand. The odds, in my view, are tipping in that direction.
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