The Fed and the Next Recession

I had so much fun last week graphing wage changes that it spilled over to another graph this week. This time, the graph plots interest rates.

Why interest rates? Because interest rates are interest-ing? Ha ha. Of course they are interesting. But a better reason to focus on interest rates today is because the worry-warts are screaming that the Fed is going to send us straight to recession hell. While many of you hate the Fed and wish we were back in the good old days of the gold standard when there was no Fed or when the Fed was reduced to less importance than a milk delivery driver, the rest of us are less extreme. But we do worry that the Fed is prone to over-reacting, thereby becoming the winner of the contest for the most severe unintended consequences. We worry in 2018 that inflation will begin rising, the Fed will raise interest rates, and the economy will come crashing down around our ears.

So, we are all riveted on interest rates. And if we looked at interest rates in the summer of 2018 and compared those rates to those in mid-2016 or even mid-2017, we might get a wee bit scared. But the point of today is to create a longer historical perspective.

First, let’s define the interest rates plotted below. Both are market rates* on government securities. The top line is the rate on 30-year Treasury Constant Maturity Bonds. The bottom line is the rate on the 10-year Treasury Constant Maturity Bond. Neither of these is a policy variable directly controlled by the Fed. But both are very popular and are generally taken to be barometers of market interest rates. Many market rates are influenced or tied to the 10-year rate. The 30-year rate is a good proxy for longer-term bonds in general.

If the Fed implements a policy to raise interest rates, it usually conducts an open market operation whose intent is to change something called the Federal Funds Rate (FFR). A change in the FFR then raises the cost of funds and ought to impact many market interest rates. A successful Fed policy, therefore, will result in a wide swath of interest rates changing even though the Fed only directly controls the FFR. It is possible, however, that many of these market rates do not behave as the Fed desires.

The graph shows that market rates have risen in predictable fashion in 2017 and 2018 as the Fed raised the FFR. The FFR was set at virtually zero from around 2009 through most of 2015. Notice, however, the roller-coaster rides of both rates in the chart. The trend of both rates was clearly downward but there were very clear episodes of rising/falling cycles within that downward trend. With the FFR constant, there must be other things that affected interest rates. Notice the increases in rates around 2011 and then again in 2012 to 2014. Both of those periods saw rates rise and then fall by about as much as they rose. All this happened with a near zero FFR. 

If these other things could be important from 2009 to 2015, then presumably they might be important in 2018 and beyond. That is, if the Fed decides to raise the FFR rate in 2018, perhaps market rates will not follow. Perhaps other factors will keep rates from rising or even contribute to a fall. And this means knee-jerk forecasts that a Fed tightening cycle will lead to a recession could also be wrong.

What are these other factors that might prevent market interest rates from rising as the FED increases the FFR? First, consider real GDP growth in the US. Rapid growth often puts pressure on financial markets as the demand for loans exceeds the supply. But who is seriously forecasting strong economic growth in the US? While some forecasters imagine faster growth emanating from the recent tax cuts, few of them think growth will remain strong for very long. A barrage of studies worry that low productivity and labor supply growth imply weak US growth for the foreseeable future. Look at the diagram. The 30-year rate is barely rising compared to the 10-year bond.

Second, interest rates often reflect expectations of future inflation. Higher expected inflation means a lender gets paid back in dollars that are worth less. So they demand a higher interest rate today to compensate for the loss of buying power tomorrow. It is true that some forecasters believe that inflation is going to increase in the USA, but few see reasons for sustained higher inflation in the future.

Third, the value of the dollar is important for interest rates. If the dollar declines in value relative to other key currencies, this leads to more inflation in the USA. If one believes the dollar will fall in the future, this means investors will want to move out of US assets. The selling of these US assets raises interest rates. The dollar has not been depreciating lately. It has been rising in value. This reduces inflation and interest rates. Believing the dollar will continue to rise also lowers interest rates*.

Fourth is the risk scenario in other countries. As investors worry about economic problems in Europe (Italy, Britain ) and Asia (Korea, Japan), they increasingly want to invest in the USA. Even with warts in the USA, what matters is who has the bigger warts. The more negative news you read about Europe and Asia, the more the global appetite for US assets increases. This drives the price of US bonds upward and reduces interest rates. 

In summary: Modest US economic growth, stable inflationary expectations, a higher value of the dollar, and economic riskiness in Europe and Asia should all combine to put downward pressure on interest rates.

I cannot predict the future any better than you can. Some folks want you to believe that Fed policy will raise market interest rates and take the air out of the US economy. While Fed policy sometimes works that way, 2018 and 2019 are not typical years. It is altogether possible that the Fed will continue raising the FFR, and the result will be a continued slow growth economy with relatively stable inflation and interest rates. 

*Students often have trouble with idea that higher bond prices mean lower market interest rates. This is because we forget the these bonds have a fixed coupon yield or return. One bond might promise 5% to the holder. Thus a $100 bond gives whoever buys the bond $5 each year. If you buy such a bond in the open market on a bad day when the price is only $50 then you get $5 interest on your $50 investment. That's a 10% return! The lower market price for the bond means a higher market interest rate. If you buy the bond on a big day for the bond market, you might pay $200. You still get interest of $5 and therefore your market return is only 2.5%. So we get the general rule -- the higher the market price of the bond the lower the market return. The lower the market price of the bond the higher the market return. 

Depreciating the Dollar

Secretary Mnuchin was asked if he ever spanked his child. He said he had heard that a spanking might be an effective parental tool at times for some children. The next day, he was arrested for advocating spanking to world leaders.

No not really. He did not say that. But Mnuchin did say he had heard that a depreciated currency might lead to more exports from that country. Immediately he was piled on by everyone from Tiny Tim to Tom Brady. Despite Mnuchin repeating a mantra found in almost every book on international trade, the world decided that Mnuchin had cleverly advocated a US policy to reduce the value of the dollar. Shout it from the housetops -- the new US policy is to depreciate the dollar so exports will rise and Americans will be protected from the world's vandals. No, not really. Could the press get any lamer?

But this is not about beating up the press. It is about ideas and facts. The first fact is that the dollar, despite limping a bit lately, is pretty darn strong. Second, most of us haven't a clue what it means to have a policy to depreciate the dollar. So let's work on that today. First, do 10 burpees.

The lovely chart below I graciously got from our good friend FRED at the St. Louis Fed. https://fred.stlouisfed.org/ It shows the exchange value of the euro versus the dollar. The euro is just one of many currencies I could have used, but this one is fine for our purposes. The chart shows that before 2000, one euro was able to command about 1.15 dollars. By 2008, the euro greatly appreciated (the dollar depreciated) to where one measly little euro could buy almost 1.6 dollars. At that time, the dollar was really weak. At the close of the business day on Friday, January 26, 2018, the quote was 1.24 dollars to a euro. Since 2008, the euro is much weaker and the dollar is much stronger.

• Since way back before 2000, the dollar weakened considerably through about 2008.
• Since 2008 the dollar is much stronger
• Since 2009, 2010, and so on the dollar is stronger
• There is a weakening of the dollar since sometime in 2017.

As far as the euro data show, the dollar is pretty strong. Things have turned of late but clearly not enough to change the general impression of a strong dollar.

So my first point is that there is no evidence of any real weakening of the dollar. But what if this short-term turn means the dollar is going to continue to fall. So what? And would our government want that outcome enough to actually promote it?

Even small birds know that a depreciated currency is good for exports, right? Sorry Charlie, but not really. Often a depreciated currency simply means a country's goods have become less competitive in global markets. If foreigners prefer France's goods over US goods, they don't need as many dollars and thus the value of dollar falls. Thus the depreciated dollar may simply be the sign that a country's goods have lost favor in the world. A falling dollar does nothing to heal the thing that produced the decline in competitiveness.

But that is not the whole story. Not by a long shot. A depreciated dollar means that US households who want to import Cognac from France or sausages from Germany will find all that stuff costs more. If they really prefer these imported goods over US goods and continue buying them, then they have to pay more. Ouch. I am not sure our US government wants to be responsible for that ouch.

And that's not even the whole story. We love it when foreigners invest in the USA. If they buy stocks, they drive the stock market up and we get richer. If they buy bonds, they drive interest rates lower and we can borrower cheaper. If they invest in new businesses, employment and wage opportunities improve. In short, we love it when foreigners invest in the USA. If foreigners believe the dollar will fall, then this weakens any returns they would expect to gain in the USA. That's because to bring their earnings home to their countries, they will have to use a depreciated currency. Would Mr. Mnuchin really want to be responsible for telling those foreigners not to invest in the USA?

It is true that some countries -- especially developing countries that rely greatly on foreign exports for growth and development -- take measures to depreciate their currencies. It is unfair and it hurts the US when these countries do so but that does not mean that it makes sense for rich, industrial countries like the US to copy them. Often when these countries behave like that they are breaking international trade rules, and there are ways to address those issues without following bad policy with more bad policy.

Furthermore, playing exchange rate bingo with the rest of the world is not a winning strategy. We can hope to expand our exports by depreciating the dollar but then export-dependent countries will simply retaliate. They have much more to lose than we do. It is hard to see us winning that game and in the meantime we all suffer.

Mnuchin denied it was the policy of the USA to depreciate the dollar. Let's all hope he really means that.

Currency Manipulation Fairy Tales

More and more is being written about exchange rates. The US is accusing other countries of illegally manipulating their currencies and gaining unfair advantage in trade. Could this be another deflate-gate? Or is it just another attempt to deflect and persuade? In truth, most of us know little about exchange rates and wouldn’t know a manipulation if it twerked right in front of us.

So let’s begin at the beginning. The Lord created man and then the exchange rate. ... OK, not really. The modern exchange rate became useful after countries moved from barter to currencies, and people starting trading across borders. As you can imagine, Germans preferred being paid in dm (note: dm stands for deutsche mark. And yes, I know there are no longer dms or French francs or French fries). If Pierre wanted to buy a beer in Berlin, then he needed to swap some of his francs for dm. The exchange rate would determine how many dms Pierre could get in return for one franc. 

Let’s suppose a beer cost 10 dm in Berlin. If the exchange rate was 1.0, then that would mean Pierre would need 10 francs to acquire 10 dm, and therefore buy one beer in Berlin. Let’s now move forward and think of a hypothetical time after the French government flooded the country with francs. Now each individual franc is worth less. Now it takes, say, 20, francs to buy a beer in Berlin. If it took way too many francs to buy dm, then Pierre might not buy that beer in Germany, save his francs, and buy a Fischer's back home.

The above example illustrates the following. First, currency exchange is a common everyday practice relating to trade across borders. Second, the exchange rate is impacted by markets and governments. Third, in the above example a surplus of francs relative to the demand for francs can cause the franc to depreciate in value against the dm. Fourth, I can’t remember the fourth one. Oh yes. The depreciated franc makes foreign goods more expensive to Frenchies.

The exchange rate can be impacted by many events. For example, let’s suppose French people decide that French goods are inferior to German ones, and they shift their buying preferences toward German goods. If they are going to buy more German goods, then they will need to exchange more francs for dms. Thus the market value of the franc falls and the value of the dm rises.  

The above applies simple ideas about supply and demand to exchanges of currencies. If demand goes up for a currency then its value rises. We say it appreciates. Supply of a currency goes up and its value falls. That's called a depreciation.

WAKE UP. This is not over yet. The fun is about to begin. Let’s suppose you are a German and the value of the dm rises. You might have one of two reactions. If you love to buy French wine, you are very happy because a stronger dm buys more francs and therefore more French wine. If Juergen sells machinery to French buyers, he is very sad because now his goods cost more to French persons and he worries they will stop buying his equipment. Every time the exchange rate changes, some people are benefited while others are hurt.

That means that the value of a country’s exchange rate is always and everywhere a policy/political indicator. Since those who are hurt by exchange rate swings always yell louder than those cheering, we have an opportunity for politicians to ride in and save the damsel in distress.

So what can a good politician do? Ha ha – a good politician! I'll drink to that! Anyway, there are two typical ways a country can address an exchange rate problem. First, the country can intervene in exchange markets. If their currency is too strong and muscular, they print up lots of bright shiny notes and sell them in the market. Thus they acquire foreign currencies as they reduce the luster and price of their own. If their currency is instead weak and puny, they can sell the foreign exchange and buy their own currency from the markets, thus raising the value of their currency.

The second way to manipulate the value of a currency is through the use of monetary or interest rate policy. Compared to the first way described above, this approach is less direct yet just as effective. When the Fed engaged in all manner of monetary increase after the great recession of 2008/2009, the result was to reduce US interest rates, cause world investors to invest elsewhere, reduce the demand for dollars, and viola!, reduce the value of the US dollar. The Fed said this policy was necessary to stimulate the US economy by the usual domestic policy means. But the larger truth is that it was also aimed at reducing the value of the dollar so that US exports would be better priced in world markets. There is no question that the Europeans, Japanese, and others have caught on to this gambit and are now imitating the Fed. 

Let’s face it. If a country is facing a very weak economy or a recession, it is going to use one or both of these methods to stimulate its economy. The more important are exports to that country the more the temptation. Thus currency manipulation is like the last JD of the evening. You swear you will not do it and decry its worth, but once the party gets going and the Stones are on the Victrola, you are the first to pour one last nip.

It is truly ironic that the US is making such a fuss over currency manipulation when our own actions are so responsible for the vagaries of the high dollar today. It was us who used monetary policy to cause the dollar to swoon faster than a pelican above a catfish farm. It is again us today with our stronger economy and rising interest rates that now makes the dollar rise. To be sure, other weaker economies are contributing to the rising dollar with their own manipulations, but pointing a finger of blame at them is like getting mad at your children for raiding your unlocked JD cabinet while you are at open mic night at George and Wendy's. 

Unfair Competition with Exchange Rates

On September 15, 2015 I wrote about exchange rates and said they were wild and crazy, like Steve Martin. I looked back over my previous posts and I have quite a few aimed at exchange rates and exchange rate policy. So for those of who are retired or simply bored I encourage you to spend a day or two memorizing all that stuff. My main reason for mentioning those past pieces is that they have a lot of background about exchange rates that I will avoid today as I focus on exchange rate data. 

My reason for writing about the data is that the word data sounds cool. Data this data that. Data is almost as cool as heteroscedasticity. But nevermind all that. Data is full of stories. Data without good statistical analysis means little but it can make you think. 

One thing we hear over and over these days is how China and many other countries take advantage of the USA when they depreciate their currencies. When other countries depreciate their currency that action appreciates the dollar and makes our exported goods less competitive. The story goes on that we have to shut down factories, fire workers, and make widows sew undergarments for Donald Trump.  Of course, the impacts of an appreciating currency are not that simple, but politicians like simplicity.

Today, instead, I share some data on this story about the appreciation of the US dollar. First, I will describe the data. I am using six key exchange rates for this analysis. The first five are well-known and are expressed as how many of the following currencies one can get with one dollar – European euro, Japanese yen, Canadian loonie, Mexican peso, and Chinese yuan. No offense to the Swiss or Brits, but I wanted to keep this manageable and I think the currencies I chose are the main ones for the dollar. A sixth exchange rate is a trade weighted index of the dollar evaluating it against a very broad group of currencies. Think of  TW as indicating how the dollar is doing against the currencies of nearly all our global trading partners.

So one decision I made was to choose these six exchange rates. A second decision related to examining changes over time. Did the dollar appreciate? The answer depends on the time period for the comparison. So here is what I decided. First, my data starts in 1999 – the starting year for the euro currency. Second, I eyeballed the data and decided that there were turning points in many of these currencies at or near the beginnings of 2005, 2008, and 2015. I agree, the results might have turned out somewhat different if I had chosen different dates. Third, I chose to use the data in January of those years. My table compares the April values of the exchange rates in 2016 to the January values in 1999, 2005, 2008, and 2015. All the data came from  https://research.stlouisfed.org/fred2/graph/

Check out the table below. The top half of the table has the actual exchange rates. Reading across the first line you can see the value of the dollar in January of 1999. In January of 1999 one dollar could purchase 86 euro cents. That dollar could also get 113 yens, 1.52 loonies, 10.13 pesos, or 8.28 yuans. The index number for what a dollar could buy in terms of a large number of currencies was 114.47. The second line shows you what the dollar could buy in January 2005. The fifth line shows you similar information for April 2016.

Let’s now use that information to see how the dollar has fared. Take the long haul first. Let’s look at the last column which contains information about the TW, the trade weighted value of the dollar. It was 114.47 in 1999 – 17 years ago. Some of you were mere children 17 years ago. In those 17  years the TW dollar value went to 119.5. In those 17 years the dollar appreciated by 4.4%.

This 4.4% increase in the value of the dollar against most of the world’s currencies supports the notion that the dollar appreciated. The question is what you make of that information. If we divide 6.6% by 17 years we could say that the dollar appreciated by an average of 0.3% per year. If we compare that 4.4% change over 17 years to changes in GDP or inflation or your waistline, you would conclude that 4.4% is not a huge issue. Or think about how much US firms might be impacted by the 4.4% increase in the dollar. Suppose those firms raised their prices by a total of 4.4% over the course of 17 years. Is that enough to convince you that those firms became less competitive? Were they forced to shut down because of this 4.4%? Is this a red herring so that politicians can protect us against evil beasts lurking in dark forests?

So you ask – Larry what in the Hades is this TW thing? Let’s instead talk about that evil monster China. Hmmm – how much did the dollar appreciate against the Chinese currency? The chart shows that a dollar could get you 8.28 yuan in 1999 and 6.5 yuan in 2016. That is NOT an appreciation of the dollar. The dollar fell against the yuan by 21% since 1999. Looking down the China column in the bottom half of the chart shows that the dollar has fallen against the yuan since 1999, since 2005, and since 2008. Only if you measure over the last 15 months can you see the dollar rising against the yuan – by less than 5%.

One more calculation -- how the dollar fared during the 11 year period between 2005 and 2016. The dollar appreciated at roughly a 5% to 9% clip against the Yen, the Loonie, and against our major trading partners. It is up 16% against the Euro, up 58% against the Peso, but down 21% against the Yuan. Much of that occurred after it became known that the financial crisis was spreading from the US to the rest of the world. As those countries are recovering and showing more stability today there is less need for the dollar to provide cover.  

Since I am running out of JD and your patience, I will end with this. The dollar is not greatly appreciating against anything in general. It is clearly rising in the last 15 months, except against the yen. But that increase is smaller than the increases that occurred right after the global recession spread. Further, if you look at the value of the dollar today you see some very different stories from country to country. 

The dollar has appreciated greatly against the Mexican peso while mostly depreciating against the Chinese yuan. If you want to find stories explaining subpar US growth and employment I suggest you look beyond exchange rates. There is no clear story here. More than likely the dollar strength reflects the weaknesses in other countries.  If and when the rest of the world stabilizes the dollar will return to a lower level. I doubt that political attacks on our trading partners will do much to normalize the dollar. 

Table. US Dollar Value Relative to Selected Currencies, 1999 to 2016

Date Euro  Yen Loonie Peso China TW 1999 0.86 113.29 1.52 10.13 8.28 114.47 2005 0.76 103.34 1.22 11.26 8.28 109.58 2008 0.68 107.82 1.01 10.91 7.24 98.65 2015 0.86 118.25 1.21 14.70 6.22 112.77 2016 0.88 108.07 1.30 17.76 6.50 119.50 Percent Change  to 2016 since 99 2.0 -4.6 -14.4 75.4 -21.5 4.4 since 2005 15.5 4.6 6.1 57.7 -21.5 9.1 since 2008 29.6 0.2 28.7 62.9 -10.2 21.1 siunce 2015 2.3 -8.6 7.2 20.9 4.5 6.0 Note: Exchange rates are foreign currency units per dollar in January of each year The quote for 2016 is April of 2016.

Lesson 12 Balance of Payments: 2015 Data is in or is it?

As my loyal followers might recall, some of my posts are a tad more educational than others. Those of you who have degrees in silly things like fine arts and biology often appreciate my patient and vainglorious attempts to make every day complicated economic concepts even more complicated. If you look back among the 9,763 stories I have posted in the last 217 years you will see 11 such insightful JD motivated dramas. Today is #12.

Balance of payments is one of those sad macroeconomic indicators that MSW grads from Harvard know nothing about. If you asked all the remaining presidential candidates what BOP means they would probably guess it is the name of a dance invented by Bill Haley and the Comets. So I have chosen a wonderful topic for today’s blog and I want you to know that a test will follow.

BOP is a pretty optimistic and archaic name for data that attempts to record all cross-border or international transactions. Wow – what a goal – to record all international transactions! So let’s start out with the very well-known fact that BOP data are about as accurate as a CNBC presidential poll.  The BOP data is a noble gesture but if you think it is hard to measure how much your kid earned at her Lemonade Stand today, then imagine trying to account for ALL cross border trades in goods, services, stocks, bonds, bank accounts and what the Tuna would refer to as college boys gone wild in Tijuana.

But they try. I won’t defend the methods except to say that people who do this kind of thing are vastly underpaid professionals and most of them care very much about doing a good job. And who would bribe the guy in charge of measuring the exports of Chevy hubcaps to Havana? These government workers are saints and deserve a two-for one coupon at the Colonel Sanders Restaurant of their choice.

Before I get into the nitty gritty, I want to say in all seriously (ha ha) that BOP is the main event these days and helps us to understand things like economic growth, interest rates and so on. For example, BOP changes should help us understand why the dollar rose by 20% last year.  So don’t get lost in the trees – a forest of delicious fruits will unfold if you stick with this. Your life will never be the same. 

Let’s start with the easy stuff. Exports are the goods and services we ship to other countries. In 2015 we shipped $2.2 trillion to our trading partners. Of course we also bought that same kind of stuff from foreign countries and that amounted to $2.7 trillion in 2015. If you music majors can do the math, that means that we had a goods and services trade deficit of about $500 billion in 2015. I had a reading deficit once and that was not pleasant. So you can imagine the anguish when a lovely country like the US has a goods and services deficit of $500 billion. But here is the cool part. This deficit means that there are $500 billion dollars scattered across the world that didn’t want to buy US goods and services. We sent them $2.7 billion but they only sent $2.2 billion back. Thus they are holding $500 billion.

The suspense builds. What did foreigners do with all that money? Probably the first thing that comes to mind is to get rid of it. If you don’t want dollars – then you probably sell the dollars for renminbi or yens or some other currency. If that was the only outcome, then all that selling of dollars would probably cause the value of the dollar to depreciate.

But foreigners have other choices. They can use the dollars to invest in America. In this case invest should be taken broadly meaning they can use the dollars to open bank accounts, or buy stocks and bonds, real estate, a US company or buy a famous US monument like Mount Rushmore or Stone Mountain. If they do that instead of selling their dollars then the dollar does not depreciate and instead the prices of financial assets increase and/or interest rates decrease.

Back to the BOP accounts in 2015. Something called the Current Account measures exports, imports and a couple of other things. The exact deficit in the current account in 2015 was $484 billion after being $390 billion in 2014. Thus in 2015 we left even more dollars around the world.  But the Current Account is only half the fun. This brings us to what is called the Financial & Capital Account. Here is what I learned about the F&C account in 2015. After adding $977 billion to their US assets in 2014, foreigners only invested another $426 billion in the US in 2015. That is quite a turnaround. If I stopped the story there it would appear that in 2015 the dollar should have depreciated since foreigners were not pouring their dollars into US exports or US assets. All that would  make the dollar sound pretty unpopular.

But there is one more part to the F&C Account. That part has to do with US investments abroad. In 2014 US citizens added $792 billion to their foreign asset holdings. In 2015 that number fell to $242 billion. US citizens were investing more at home rather than abroad. Now put these two facts together – foreigners were investing less in the USA and US citizens were investing less abroad. In a crazy uncertain world, money was staying at home!

Cutting through all the numbers – according to the Current Account $484 went out of the USA for goods and services in 2015. According to the F&C account $209 billion came back to the USA to buy financial stuff. Thus there are $275 billion unaccounted for in the usual transactions in the BOP. Where are those dollars and what are they doing? Somehow they must be desired because during 2015 the value of the dollar increased. I think most of us know that global tensions created a healthy appetite for US dollars. But somehow BOP is not fully recording that appetite.

Right now that $275 billion is recorded in the F&C account as a “statistical discrepancy.”  Or in an accountant’s words—we have a $275 billion fudge factor in our accounting. I am guessing that revised data will show more foreigner investment in US assets. One likely suspect is governments who bought dollars in an attempt to depreciate their currencies. Otherwise the BOP data leave it very hard to explain a 20% rise in the value of the dollar in 2015.