The Real Reason the US Dollar Can’t Lose

One of the big scares out there is there will be a shift away from the U.S. dollar into the Chinese Yuan, and this shift will drive U.S. interest rates dramatically higher. Here’s the Economist throwing in a rather silly statement:

“The good news for the dollar is that the Chinese yuan is not yet widely accepted and suffers from higher inflation, reducing its usefulness. But a shift in the world’s reserve currency could be swifter than many assume.”

This is simply silly. A multi-trillion real value shift can’t happen quickly. The United States still has a huge proportion of valuable real assets. Foreigners want access to those access, and that involves getting U.S. dollars at some point. The value of the dollar is tied to the getting access to U.S. markets.

Imagine the consequences of a shift to the Yuan on the price of the Yuan and the consequences for the Chinese economy. People trade in several trillion dollars of USD for Yuan. Suddenly, all of the benefits China supposedly has over the United States vanish – no labor cost advantage, no pricing advantage, unable to export it’s extremely expensive goods.

Under the “reserve currency shift” scenario, China no longer has another 40 years of 8% real growth, but rather 2% real grown. The U.S. real growth rate jumps to 6%.

It might not be impossible for the reserve currency status of the United States to vanish over a decade, but it’s extremely unlikely. It’s far less likely for this shift to happen in less than several decades.

 

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31 Comments on "The Real Reason the US Dollar Can’t Lose"

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jt26
4 years 11 months ago

There’s also expectations/options on the nation itself that make it the reserve currency, size is one aspect, production is one aspect, but given a war, famine, disease, deficit in technology, loss of freedom, where would you place your best bets on coming out ahead? China? Not a chance; not yet anyway.

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wh10
4 years 11 months ago

Does MR have a position on the link between reserve currency status and the interest rate on US debt?

Admin
4 years 11 months ago

Reserve status is largely a function of production. Biggest economy = reserve status by virtue of demand/need/safety of that currency. Having a smaller less dynamic economy makes it harder to be totally autonomous so there’s definitely a degree of exorbitant privilege involved in being the reserve status nation, but it’s not like the USA would collapse in a ball of fire if the Euro or Yuan were to become the reserve currency. It would just mean the USA is a slightly smaller economy. It wouldn’t necessarily make us more susceptible to problems necessarily though I wouldn’t discount the fact that a stagnant economy or shrinking economy would likely be accompanied by other issues…..Ie, it wouldn’t change our status as autonomous and able to control rates.

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JK
4 years 11 months ago

I would think the interest rates on U.S. debt is primarily determined by the market, i.e. supply and demand for Treasuries relative to other avenues of investment.

Being the reserve currency should increase the demand for U.S. Debt, pushing the interest rate lower than what it might be. As Cullen has said many times though, technically the Fed could set any rate along the yield curve by simply announcing it’s target and implicitly challenging the market. “Don’t fight the Fed”

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wh10
4 years 11 months ago

Yeah – I guess I am trying to resolve the importance of demand vs the Fed/Primary Dealers/ expectations hypothesis.

Guest
wh10
4 years 11 months ago

Or I guess what I am really wondering is, if the Fed has to act to bring interest rates down lower than otherwise, what does that mean for the broader economy? At full employment, is that inflationary?

Guest
4 years 11 months ago

I recently attempted to address the question of market-determined vs. expectations determined interest rates (http://bubblesandbusts.blogspot.com/2012/08/markets-determine-interest-ratesuntil.html). Scott Fullwiler agreed that the Fed may choose to follow T-bills in its actions but that expectations still largely determines rates across the Treasury curve.

As for full employment, I think the issue with higher rates becomes political in the sense that interest payment will consume a larger portion of federal spending. This only implies inflation if Congress chooses not to reduce spending elsewhere or raise taxes enough to limit the deficit to a level that is not inflationary at that time.

Lastly, for Mike, not sure if you’ve read it but there’s an interesting paper by David Fields and Matias Vernengo on Hegemonic Currencies during the Crisis:
The Dollar versus the Euro in a Cartalist Perspective (http://www.levyinstitute.org/publications/?docid=1374). One quote applicable to this debate is “It is the power to coerce other countries that is central
for monetary hegemony. (p.7)” So unless China is soon in a better position to coerce other countries, which I doubt, the US dollar is likely to retain its importance in global trade.

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JKH
4 years 11 months ago

Mike,

Rough thoughts:

The Fed determines the real fed funds rate, right?

(Because it determines the nominal rate in whatever inflation environment it faces.)

All other overnight rates propagate from that, including risky and “pure” risk free overnight t-bills (Although the fed funds rate is fairly close to risk free).

And yield curves for all asset classes propagate out from that, based on expectations and risk.

So you could extract various “spread curves” (including the real rate itself) and decompose them into “expectation” and “option premium” components.

So the long term real rate could be an expected real fed funds rate plus an option premium for volatility.

Then there’s inflation and expected inflation and inflation volatility.

Then there’s credit risk and expected credit risk and credit risk volatility. For example banks price expected losses into credit spreads, and unexpected losses (loss volatility) into capital requirements – i.e. capital requirements are determined something like a present value option premium based on volatility of losses – equity is an option on assets at a strike equal to debt – etc. So the option pricing meme is consistent there.

As I said, rough only.

Guest
4 years 11 months ago

Thanks for the compliment. I completely agree regarding the quality of comments here. As someone still in the relatively early stages of learning about these topics, I can’t fully express my gratitude to you, JKH, Ramanan and others for engaging in these discussions openly.

My curiosity with that post is determining whether expectations are based on the Fed’s actions, the market’s demand for credit or conceivably a combination of the two. I think the comments by STF and those here regarding expectations with a measure of optionality makes sense.

One aspect I didn’t consider is the role of private bank expectations. If banks expect the Fed to move in a certain direction, they might start shifting loan rates and portfolios in advance. The, if the Fed is following the market, those expectations will become reinforcing of themselves. This doesn’t appear to alter the specific measures used to determine the option premium but might offer a view at which sector(s) drives the pricing of that premium.

Guest
JKH
4 years 11 months ago

You can’t test the hypothesis that term rates are determined by expectations for monetary policy simply by tracking the two ex post.

The fact is that expectations are continuously correcting themselves. They’re almost always wrong, in the sense of “to the penny”.

Otherwise, there’d be no measure of volatility in any market, which is absurd.

Obviously, not every market participant is factoring in a yield curve calculation based on a projection of expected monetary policy.

But it’s only rational to assume that this is a big part of it, implicitly, if not implicitly.

My favorite textbook example of this is the 93-94 Fed tightening cycle. You can see bond market yields reacting viciously to Fed tightening expectations in early ’93, followed by yield curve flattening as the market got its arms around the expected finite extent of the tightening, followed by yield curve inversion as it anticipated eventual easing.

The Fed does NOT control the yield curve. This is rhetorical overreach. It CAN control the yield curve, but only in a counterfactual, where it is prepared to offer an unlimited 2 way market on yield curve points other than the overnight funds rate. That is not what it does in fact, normally.

(Agree with STF comments there)

Guest
4 years 11 months ago

yes, multi-factor interest rate models can be used to get inverted yield curves.

But they can’t be expected to do well. For example, now the interest rates have been low but historical data used for calibration may give a “wrong answer”. It looks as if very little will be done in the fiscal side implying inflation and growth will remain low and unemployment high for a long time and thus implying the Fed will keep the Fed Fund rate lower for longer. This will imply the expectations of markets will change to rates remaining low for a longer time in the next 0-10 years or so (as has been happening over the last 2-3 years). Models can’t replace human experience and judgements IMO.

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JKH
4 years 11 months ago

Also, the zero bound starts to look like an option strike price as rates get closer to it. There is nearly perfect nominal rate asymmetry at the zero bound (although bill rates etc. can go negative). Which means asymmetry increases as rates approach the zero bound, other things equal, I guess.

That crusty options trader, Paul Krugman, pointed this out a while ago.

Guest
4 years 11 months ago

I agree with JKH about expectations hypothesis and the optionality and also that one’s can’t track them ex post and prove it. (because that kind of argument would mean the future is foreseeable, which is a bit absurd).

Actually some derivative pricing can be used to setup a Black-Scholes kind of equations using one factor interest rate models and then pricing the long term bonds. The trouble with this approach is that it doesn’t lead to inverted yield curves. The reason is that “expectations” used by economists differs from concepts used in BS pricing and there is no notion of liquidity/portfolio preference in this.

Also, Kaldor also said something similar:

“To ‘borrow from individuals and institutions’ by means of the sale of Government securities what matters is the additional yield which has to be offered on such securities as compared with the current rate of interest on bank deposits (or Treasury Bills) and the expected future short rates of interest during the lifetime of the security issued. For the cost to the buyer of purchasing long or medium term securities is the sacrifice of foregone liquidity….

…It is not a question therefore of inducing individuals to save (in the sense of inducing them to refrain from current consumption) but only of inducing them to commit themselves to a purchase of a long-term security which is subject to the risk of a capital loss (as well as to the chance of a capital gain) on account of future changes in the rates of interest.”

Guest
Fed Up
4 years 11 months ago

JKH, what is your opinion of this?

Interest on Excess Reserves and Cash “Parked” at the Fed

http://libertystreeteconomics.newyorkfed.org/2012/08/interest-on-excess-reserves-and-cash-parked-at-the-fed.html

Thanks!

Guest
JKH
4 years 11 months ago

good article, and accurate

Keister has written several good pieces on reserve management over the past few years

Guest
JKH
4 years 11 months ago

velocity – he’s talking about volume in the fed funds market, pre-crisis compared to post-crisis; it’s an interesting but unusual point – I don’t know how that volume normally compared with regular interbank clearing exchange volume for customer transactions, although he may not be thinking about the latter when he uses the term “velocity”

you’re right on the second point

Guest
Fed Up
4 years 11 months ago

http://libertystreeteconomics.newyorkfed.org/2012/08/interest-on-excess-reserves-and-cash-parked-at-the-fed.html

In the comments,

Blog Author said: “In response to Ted: The velocity of [central bank] reserves largely reflects the quantity of interbank lending and is somewhat divorced from other economic activity” (I’d say that as from activity in the real economy).

It seems to me that is correct. Is it?

James Salsman’s post said: “”The resolution to this apparent puzzle is that when one bank decides to hold a lower balance in its reserve account, the funds it sheds necessarily end up in the account of another bank, leaving the total unchanged” (from article)

Except it gets there by way of a transaction, e.g., the sale of a house by mortgage. Sheesh!”

I don’t think that is right. The transaction may occur inside the banking system covered by the fed. The transaction may not occur in the real economy. Is that right? Thanks again!

Guest
4 years 11 months ago

JKH,

Slightly unrelated … (although one could say everything is related).

Have you seen #18 here: Ben Bernanke Q&A from Aug 22.
http://blogs.r.ftdata.co.uk/money-supply/files/2012/08/doc-1.pdf

I think you will quite agree with his answer.

Guest
JKH
4 years 11 months ago

Thanks, Ramanan.

Noticed how he deliberately stayed away from the (non) relationship between reserves and lending? He’s quite aware of that.

When Sumner first started his blog, I offered the case that excess reserves were a consequence or a by product – not a direct objective – of QE policy. He said he’d never heard anybody describe monetary policy in such a strange way 🙂

Funny how the Fed typically ends up producing the most articulate and sensible writing and explanation of monetary policy – amidst all of the academic butchering of same.

Guest
4 years 11 months ago

Yeah true.

Admin
4 years 11 months ago

I use the example of the Fed walking a dog. It can always control the yield curve, but tends to let the slack out the further out the curve we go. But there’s an element of circular thinking here given the environment. For instance, in the 70’s the Fed felt compelled to raise rates to snuff out inflation. Yes, the Fed could have just left rates at 0%, but they raised rates to snuff out inflation (or at least that’s what they thought). So, depending on the environment, the Fed NORMALLY walks the dog, but in the wrong kind of environment the dog walks the Fed. A hyperinflation is almost certainly an environment akin to walking a 200 pound Rot around the neighborhood thinking you’re in control just because you tied a leash to the dog’s neck. The govt can control what MR calls acceptance value (through laws, taxes, etc), but not quantity value (purchasing power, fx, etc). And once that quantity value deteriorates/collapse the govt has few tools that can fix this. And raising rates in such an environment is generally something that CB’s feel compelled to do though obviously, us PKers would debate whether it will actually help (but again, a lot of this depends on the circumstances so it’s hard to make sweeping generalizations like I am mostly doing here).

Guest
wh10
4 years 11 months ago

To pull the leash in, the Fed likely has to enter the market and buy (maybe not, if it is effective enough just to announce). But what is the effect on the real economy and / or prices of that asset swap and the change in interest rate? In today’s environment, QE2 has shown that it’s not that effective, at least at the size of QE2. Maybe it led to some asset bubbles? But what about in a different economic environment, like one at full employment. Will the effect be the same? Marginal, stokes temporary speculative bubbles?

Admin
4 years 11 months ago

In today’s environment I would contend that changing interest rates is definitely muted in terms of its impact because the demand for credit is low. As you know, monetary policy really works by changing the demand for credit (and the willingness of banks to issue). I’d contend, in a normal environment, like an economy at FE that monetary policy is much more powerful than fiscalists give it credit for being. For instance, I don’t think it’s a coincidence that inverted yield curves have almost 100% accuracy in predicting economic contraction. But I know this is a hotly debated point. Personally, I think the recent balance sheet recession validates the thinking that inside money is a dominant driver of economic activity. And the idea that the cost of inside money has no impact on economic activity just defies logic to me….But I am speculating to some degree….

Guest
Fed Up
4 years 11 months ago

“I’d contend, in a normal environment, like an economy at FE that monetary policy is much more powerful than fiscalists give it credit for being.”

By normal environment, do you mean real aggregate supply constrained?

Guest
wh10
4 years 11 months ago

I guess it depends on how low interest rates go and how much cash is exchanged for bonds.

Guest
wh10
4 years 11 months ago

Thanks Josh- will take a look.

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