QE2 and the Dollar: How Fed Policy Can Boost Growth
Opinion

QE2 and the Dollar: How Fed Policy Can Boost Growth

• The trade-weighted dollar is down more than 6 percent since June.

• QE2’s effect on the dollar will lift GDP growth by 0.3 percentage points.

• Commodity prices have jumped $20 percent since August.

 Talk about strange bedfellows. In recent days both Sarah Palin and Alan Greenspan have criticized what they say is a U.S. policy intended to weaken the dollar. Greenspan’s remarks in the Financial Times last week were especially jarring, given that Federal Reserve officials well know the damage a few misinterpreted words about the greenback can inflict on volatile currency markets. Treasury Secretary Timothy Geithner felt it necessary to publicly rebuke the former Fed Chairman, saying that Greenspan’s remarks did not accurately reflect current policies of either the Federal Reserve or the Treasury.

It’s all part of the growing debate, both at home and abroad, over the Federal Reserve’s new $600 billion round of purchases of Treasury securities as a means to achieve its dual mandate to promote both job growth and price stability. The question is whether or not this second round of quantitative easing, nicknamed QE2, is bad policy for the dollar and, by extension, for the U.S. and global economies.

U.S. policy helped to put a chill in the air at the recently concluded gathering in Seoul of representatives of the Group of 20 leading economies. The final watered-down communiqué Friday stood in sharp contrast to the unresolved issues of China’s currency policy and global trade imbalances, along with talk of competitive currency devaluations and trade wars. In the U.S., the fear is that the flood of credit from the Fed will fuel U.S. inflation and sink the dollar further, perhaps leading to a dollar crisis in which foreign lenders lose faith in America’s ability to pay its debts.

By all appearances, the U.S. is doing just as Greenspan, Palin, and others in the U.S. and abroad are saying. Using a Federal Reserve index, which measures the dollar against the currencies of 26 U.S. trading partners with all currencies adjusted for each country’s inflation rate, the dollar has dropped more than 6 percent since June. That decline came largely in anticipation of the Fed’s new policy efforts. The index remains within its historical range, but the latest drop has taken the dollar close to the lowest levels plumbed since the Fed began tracking this particular index in 1973.

 

There is a big difference between appearance and intent, though, and that’s a critical distinction for the U.S. and global outlooks. The Fed’s intent is to boost U.S. growth and avoid a debilitating round of Japanese-style deflation, a goal that any world leader should welcome. That’s true even for China and Germany, which have been especially critical of U.S. policy, yet depend heavily on U.S. demand for their exports. Unlike China, the Fed is not intervening in the currency markets, selling dollars and buying other currencies in an active attempt to push the dollar lower. That’s what China does in order to hold down the value of the yuan and give its exporters an advantage in world markets.

The way QE2 is expected to help U.S. growth is one of the factors feeding the perception that QE2 is a calculated weak-dollar policy. The Fed’s Treasury purchases work through three main channels to boost growth: lower borrowing costs, higher stock prices and a cheaper dollar. Many economists believe the most important channel will be via the lower dollar’s positive effect on the U.S. trade deficit, as it boosts U.S. exports and deters imports. Economists at Barclays Capital estimate that QE2 will add a modest 0.5 percentage point to economic growth over the coming year, with 0.3 point of that lift coming from a lower dollar.

A more competitive dollar comes at an opportune time for U.S. trade, which is set to shift from a headwind to a tailwind for U. S. growth. During the past two quarters, a huge widening in the trade deficit subtracted the most from economic growth in more than 60 years. Exports slowed as emerging markets cooled off and as Europe’s sovereign debt crisis took hold, and imports surged as Chinese companies ramped up shipments ahead of an expiring export subsidy.

All that is reversing now, amid signs that global growth is picking up and U.S. export orders rebounded in October. Europe remains weak, but growth in emerging markets is speeding up again. “We think that yawning overseas-U.S. growth differentials and a weaker dollar will promote a sustainable improvement in U.S. trade,” says Morgan Stanley economist Richard Berner, who is expecting a large foreign trade contribution to U.S. growth this quarter.

Stronger growth is a key factor in the near-term dollar outlook. Currency markets are already taking note of improved U.S. prospects, especially relative to Europe. Running counter to weak-dollar fears, the greenback has risen more than 3 percent vs. the euro since the Fed announced its QE2 program on Nov. 3. Recent upbeat U.S. reports from the labor markets, manufacturing, and car sales stand in contrast to continued sluggish growth in Europe and renewed worries about the sovereign debt of Ireland, Portugal and Greece. 

That’s not to say currency traders are ready to ignore the risks surrounding the Fed’s actions. Already, commodity prices, which tend to rise as the dollar falls, have soared nearly 20 percent since the end of August, with the potential to boost energy and food prices. Also, the lower dollar will push up prices of imported goods. “We are keeping a wary eye on how much more expensive imports and commodities may drain from U.S. consumers’ wallets,” economists at UBS told clients in a research note. Any big hit to household buying power could cause QE2 to backfire, they say.

Every Treasury secretary since Robert Rubin has memorized and repeatedly spoken the dollar mantra that Rubin first uttered, “a strong dollar is in the best interest of the U.S. economy.” Proponents of the Fed’s QE2 policy would agree that the reverse is also true: A strong U.S. economy is in the best interest of the dollar. If QE2 helps to lift the economy, it will also help to strengthen the greenback.

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