FX International Payments
By Frances Coppola
USD's trade-weighted exchange rate has risen since the announcement2, though to what extent this is a response to the Fed's forward guidance is unclear. Market analysts say it is partly due to the U.S. economy's resilient response to recent hurricanes. But they also warn that carry trades may exert an influence.3
A simple supply-and-demand view of reversing QE would say that reducing the size of the Fed's balance sheet reduces the quantity of money in circulation. The dollar's exchange rate is its external price, so if the external demand for dollars remained constant, then the trade-weighted exchange rate would gradually rise as the Fed reduces the size of its balance sheet. As USD is the world's premier reserve currency and the most widely used settlement currency in international trade, for dollar demand to fall significantly would imply either a reduction in global trade or rotation to a different currency such as the euro.
The euro is currently the world's second-most-important reserve currency. But it is a long way behind USD, and there is little evidence at present that its use for international trade and saving is increasing significantly.4 At the same time, global trade has improved in 2017.5 As all these factors point to little sign of falling demand for dollars, the USD exchange rate could strengthen as the Fed reduces the size of its balance sheet.
However, there is another possibility. The standard "quantity of money" equation (MV=PY) says that if the quantity of money, M, declines, then either the velocity, V, at which it circulates must increase or there must be some downwards adjustment to PY. P is the price level, so a downwards adjustment means that inflation falls. Y is output: a close equivalent is gross domestic product (GDP). So, in theory, reducing M should put downwards pressure on either inflation or output, or both. A gloomier outlook for the U.S. economy could discourage investors from buying USD-denominated assets, and therefore reduce demand for dollars. If the Fed's tighter monetary policy stance caused U.S. inflation and/or GDP to fall, therefore, the dollar's exchange rate could weaken.
The way in which the Fed goes about reducing the size of its balance sheet also has implications for exchange rates. Rather than actively selling securities, the Fed will simply allow securities to roll off as they mature. Until now, when securities have matured, the Fed has bought more to replace them. But from October 2017 onward, it will only replace securities up to a limit, and that limit will gradually rise. So, for October to December 2017, the Fed will only replace maturing securities up to a limit of $6 billion: anything above that limit will simply roll off. If economic conditions support it, then in January 2018 the limit will rise to $12 billion. Further rises are envisaged every three months until the limit reaches $30 billion.6
The Fed's aim is to ensure that its balance sheet gradually shrinks in a controlled manner without causing damaging volatility in interest or exchange rates. QE principally affects long-term interest rates, so allowing the Fed's holdings of securities to roll off should steepen the U.S. Treasury yield curve. This would be consistent with a gently rising USD exchange rate over time.7
However, some fear that the loss of dollar liquidity from unwinding the Fed's balance sheet even in such a gradual manner could trigger a financial crisis.8 This could result in rapid and sharp appreciation of the dollar's exchange rate, as happened in 2008,9 along with those of "safe haven" currencies such as the yen and Swiss franc.
How far and fast the Fed shrinks its balance sheet ultimately depends on the performance of the U.S. economy. The Fed has indicated that it could respond to a marked economic deterioration by stopping the reduction of its balance sheet, and if necessary even re-starting QE.10
But even if normalization proceeds as the Fed is currently signaling, the dollar's real exchange rate might not rise by as much as the 4.5 percent or so that the economist Gavyn Davies estimates that it has fallen due to QE and zero interest rate policy.11 The Fed has already signaled that the "new normal" for interest rates is likely to be well below the pre-crisis level,12 and economists think the Fed will also maintain a larger balance sheet than before the crisis.13
Reversing QE might be expected to raise the dollar's exchange rate over time. But if the effect of tighter monetary policy is that the U.S. economy performs less well than expected, then the exchange rate could weaken. As the Fed starts reducing the size of its balance sheet, therefore, businesses face a period of uncertainty over the path of the dollar's exchange rate.
With 17 years' experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Understanding the Federal Reserve Balance Sheet,” Investopedia; http://www.investopedia.com/articles/economics/10/understanding-the-fed-balance-sheet.asp
2. “USD Correlation-Weighted Currency Index,” Bloomberg; https://www.bloomberg.com/quote/BCWIUSD:IND
3. “Resurgent dollar hits 7-week high on signs of economic resilience,” Financial Times; https://www.ft.com/content/2fb6fb5c-2f0d-3c07-913d-7a6e9c24a249
4. “The international role of the euro,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/other/ecb.euro-international-role-201707.pdf
5. “WTO upgrades forecast for 2017 as trade rebounds strongly,” World Trade Organization; https://www.wto.org/english/news_e/pres17_e/pr800_e.htm
6. “FOMC Communications regarding Policy Normalization,” The Federal Reserve; https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm
7. “Effect of the Federal Reserve’s securities holdings on long-term interest rates,” The Federal Reserve; https://www.federalreserve.gov/econres/notes/feds-notes/effect-of-the-federal-reserves-securities-holdings-on-longer-term-interest-rates-20170420.htm
8. “Unwinding QE could trigger financial crisis, warns JP Morgan,” The Telegraph; http://www.telegraph.co.uk/business/2017/10/04/unwinding-qe-could-trigger-financial-crisis-warns-jp-morgan/
9. “What explains global exchange rate movements during the financial crisis?,” European Central Bank Working Paper Series; https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1060.pdf
10. “FOMC Communications regarding Policy Normalization,” The Federal Reserve; https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm
11. “The consequences of shrinking the Fed’s balance sheet,” Gavyn Davies blog at the Financial Times; https://www.ft.com/content/828169e8-8902-3d5a-903d-586bf22cc35c
12. “Interest rates and the ‘New Normal,’” John C. Williams, Federal Reserve Bank of San Francisco; http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2017/october/interest-rates-and-the-new-normal/
13. “Shrinking the Fed’s balance sheet,” Ben Bernanke, Brookings Institution; https://www.brookings.edu/blog/ben-bernanke/2017/01/26/shrinking-the-feds-balance-sheet/