A greenback drag on the US recovery

There has been the usual hand-wringing in recent weeks about the impact of a sliding Australian dollar, but investors at home have yet to pay close attention to the flip side of that coin.

The reason the domestic currency has fallen in a heap – 7 per cent against the greenback in the past month – is mostly a function of the remarkable surge in the US dollar.

This is the real story. The sharp 7.7 per cent increase in the US dollar against a basket of currencies in the September quarter has dramatic implications for US Federal Reserve policy next year as it seeks to start gently normalising interest rates without triggering a new financial panic.

If the greenback extends its current run – despite a temporary drop in the US dollar in the past day or so, there is nothing in the stagnant economies of the euro zone or Japan to counter the rally – then it will start to dampen US exports and economic growth, and keep inflation lower than the Fed would like.

As the giant US economy slowly drags itself out of the Great Recession, inflation has remained stubbornly below the Fed’s 2 per cent target for two-and-a-half years, since March 2012. One of the Fed’s preferred measures, based on personal consumption expenditure, is stuck around 1.5 per cent, while CPI is running at 1.7 per cent.

Now, the rallying currency threatens to push down the prices of imported goods as well. It will dampen the foreign earnings of US companies, and nearly a third of revenues of the S&P 500 corporates are derived from offshore. And that means that the Fed’s efforts to reflate the economy will face fresh headwinds.

New York Federal Reserve Bank president William Dudley, who is the head of the most influential of the 12 regional Fed banks, the Vice Chairman of the Fed, and a close ally of Fed Chairwoman Janet Yellen, said last month that if the dollar were to strengthen “a lot”, it would have consequences for growth and monetary policy.

Calculations from the OECD suggest that in general terms, a 10 per cent rise in the US dollar would cut about 0.5 percentage points off CPI in a year. That would be enough to give the central bank pause for thought on the timing of the first rate increase since 2006. The risk is that the dollar could rally much more than that.

Even without quantifying how much Dudley or his colleagues would consider to be “a lot”, the indications are that the dollar is indeed on track to strengthen “a lot”.

Research from HSBC shows the average US dollar rally historically has been about 20 per cent and lasted about a year. That excludes the mega-rallies of the early 1980s when the dollar surged 90 per cent and the 1995-2001 appreciation of 50 per cent. (When the Fed was planning and executing QE II, its second round of quantitative easing, the dollar fell by about 20 per cent.)

So far, the US currency has risen 9 per cent since May and the dollar index, measured against six major currencies, is on track for the best yearly gain in nine years. Traders are betting the greenback has more room to rise, with the latest data from the Commodity Futures Trading Commission showing that net long contracts are close to record levels, having risen for seven straight weeks to the highest since June 2013.  

Current Fed forecasts anticipate the central bank will start lifting interest rates by around mid-2015, and the benchmark federal funds rate will rise to 1.5 per cent by the end of 2015.

There does appear to be a mismatch in markets over those expectations, with some of the greenback’s rally attributed to the anticipated rise in rates. But short-dated US Treasuries are yet to reflect expectations of a rate rise and even the yield on 10-year Treasuries has dropped.

The difficulty that Fed policymakers face as they juggle their dual mandates of “maximum employment and stable inflation” is that even pointers to apparent recovery in the US economy, such as the September payrolls report which showed the unemployment rate dropped to a six-year low of 5.9 per cent, are not gaining traction.

Despite the blanket coverage given to the US payrolls report across the media every month, a truly scary survey from the highly regarded Pew Research Centre shows that 45 per cent of Americans think the jobless rate is far higher than it is. The survey, conducted before last Friday’s payrolls data, showed 27 per cent of respondents thought the jobless rate was actually 9 per cent. Another 18 per cent believed it to be 12 per cent. Only one-third of respondents got it right.

So the Fed is contemplating raising rates in a recovery that, for perhaps half the country, doesn’t feel like a recovery at all.

Some Wall Street banks are already trimming US GDP forecasts for 2015 to take into account the rising dollar. If the greenback’s current rally has longer to run, and all the signs are that it does, they will need to revisit their forecasts for Fed tightening as well.

Victoria Thieberger is a former US Federal Reserve correspondent for Reuters.