The Federal Reserve’s dollar dilemma

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It would be an understatement to say that the Trump administration has presented challenges for the Federal Reserve. With the negative output gap that followed the financial crisis essentially closed and the US economy operating at around full employment, the administration and a Republican-controlled Congress pushed forward with the sort of fiscal stimulus typically seen in response to recessions.

Dealing with fiscal stimulus and policy criticism…

As I have written previously, the Federal Open Market Committee (FOMC) has responded by largely accommodating fiscal stimulus, allowing for above-trend GDP growth and an unemployment rate that will likely remain below most estimates of its trend level for many years to come. This leaves the Fed with a significant challenge over the medium term – how to cool off the labour market gradually without engendering a persistent inflation overshoot or, conversely, throwing the economy into a recession.

Fiscal stimulus is not, however, the only challenge that the administration poses. A second is potential political interference in the setting of monetary policy. Even as the FOMC shifted its rate path projection only modestly in response to fiscal stimulus, President Trump has on a number of occasions expressed his displeasure with policy tightening.

My base case remains that the FOMC will continue to set what it believes to be appropriate policy without regard for any pressure or criticism from the administration. Committee members will play the long game – administrations come and go and the best way for the FOMC to avoid Congress intruding on its independence is to distance itself from pressure from the White House.

…and the potential threat of currency intervention

Still, it is not inconceivable that the administration could attempt to counteract any tightening in financial conditions brought about by a higher policy rate through the one monetary tool at its disposal, namely, foreign exchange intervention.

President Trump has already shown frustration with what he views as currency manipulation by other major economies and with a stronger US dollar that he views as hurting exports. Should the dollar continue to strengthen, the White House might consider foreign exchange intervention to offset or even reverse the impact of interest-rate increases on the currency. At the very least, the President’s preferred style of negotiating suggests that the threat of large-scale intervention could be used in private discussions with Chairman Powell in an attempt to pressure the FOMC to pause its rate rising cycle.

Following the long-standing practice to preserve credibility

None of this presents the FOMC with good options. Historically, the Federal Reserve not only implements interventions on behalf of the Treasury (using funds from the Treasury’s Exchange Stabilization Fund), but accompanies the Treasury in the intervention using its own funds (specifically, the Federal Reserve would participate in an intervention to weaken the dollar by creating reserves).

In all likelihood, the Fed would continue this long-standing practice. Not doing so would signal disagreement with foreign exchange policy and risk a significant rift with the Treasury Department, and would also greatly reduce the effectiveness of the intervention. This is because the Exchange Stabilization Fund, at under USD 100 billion, is woefully inadequate on its own for any sort of sustained intervention.

The intervention’s effectiveness would also be reduced in its signalling effects and potency by the fact that it would be uncoordinated – no other major central banks would participate alongside the Treasury and Federal Reserve to weaken the dollar unless there was substantial evidence that the exchange value of the dollar had moved significantly out of line with the fundamentals or that trading conditions in foreign exchange markets had become disorderly.

For these reasons, the Federal Reserve would intervene alongside the Treasury to ensure that the implementation of foreign exchange policy retains its credibility over the longer term, while attempting in its dialogue with the Treasury Department to limit the size and duration of the intervention.

Selling dollars when monetary policy is being tightened…

Still, it would be challenging for the FOMC to avoid any signalling of disagreement over an intervention undertaken at the administration’s prompting. This is because an intervention to weaken the dollar represents monetary policy easing at a time when policy is being tightened. If the Committee believes that policy should be tightened gradually over time, in theory it should respond to its own intervention with additional interest-rate increases.

However, this response would only place the contradictions of intervening during a tightening cycle squarely on the FOMC’s shoulders. As a result, the committee would likely stick to its projected path of gradual interest-rate increases, perhaps communicating that the intervention has not materially changed its medium-term forecasts for the trade-weighted dollar.

Even this more accommodative response to intervention could increase tensions with the administration as it would still distance the Fed from the White House’s preferences for the dollar. Again, there are few good options for the central bank if the Treasury Department goes down the path of intervention.

…or pause the ongoing tightening?

Another possibility would be for the FOMC to pause in its tightening cycle to reduce the likelihood that Treasury would push for an intervention that the committee views as a policy error. This, however, seems highly unlikely unless there are clear signs that dollar strength will persistently undermine the FOMC’s ability to sustain 2% inflation.

In the final analysis, the FOMC would prefer to pursue an ineffective policy (intervention) on behalf of the Treasury rather than deviate from its own preferred interest-rate path. This is because pausing in the tightening cycle in response to administration concerns over dollar strength would represent a subordination of monetary policy to political considerations, with potential ramifications for long-term interest rates and inflation expectations.

This suggests one final challenge for the Fed – with President Trump already voicing criticism of the monetary policy stance, any pause in the tightening cycle now risks being viewed as politically motivated.

To read more content written by Steve Friedman, click here.

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