FX International Payments
By Frances Coppola
The Fed’s monetary policy in the aftermath of the crisis does indeed seem to have depressed the dollar’s exchange rate against the currencies of U.S. trading partners. The trade-weighted exchange rate fell sharply at the beginning of 2009 and did not start to recover until the Fed signaled the ending of QE and commencement of interest rate rises in mid-2014.3 We don’t know for certain how much of that is due to QE and how much to historically low interest rates. However, the economist Gavyn Davies, writing in the Financial Times, estimates the fall in the dollar’s effective exchange rate from QE to be 4.5-5 percent.4
Some of the assets originally purchased have matured since, but the Fed has invested in replacement securities. In July 2017, therefore, the Fed’s holdings of financial assets still stood at $4,234 trillion.5 But now, the Fed has indicated it will start unwinding those investments – and many people are asking what the implications will be for the dollar exchange rate.
In December 2015, the Fed raised interest rates for the first time since 2007. As this was widely anticipated, the dollar’s exchange rate had already been rising for some time before the announcement, and continued to do so afterwards.
This was only to be expected, since raising interest rates encourages investors to buy dollar-denominated assets. But it was another year before the Fed raised rates again – and yet the dollar’s exchange rate rose continually throughout 2016.
By the time of the next rate rise, in December 2016, the dollar’s exchange rate had risen nearly to its peak of the early 2000s. But then it dropped. Despite two further interest rate rises, the dollar’s exchange rate declined more-or-less continually for the first six months of 2017. It seems that interest rate rises of a few basis points at a time no longer interest investors sufficiently to raise the dollar’s exchange rate.
According to the Financial Times, the dollar’s weakness in 2017 is due to concerns that the U.S. economy will not be strong enough for the Fed’s indicated schedule of interest rate rises:6 inflation is below the Fed’s 2 percent target,7 and although employment is strong, wage growth is poor.8 In July 2017, the International Monetary Fund (IMF) cut its growth forecasts for the U.S. economy for both 2017 and 2018 due to uncertainty over the path of fiscal policy.9
It seems that the dollar exchange rate could depend more on the outlook for the U.S. economy than the expected path of interest rates. Indeed, future interest rates themselves depend on the economic outlook. In its most recent meeting, the Federal Open Market Committee (FOMC) observed that inflation was below its target of 2 percent, decided not to raise rates again for the moment, and warned that it would be quite some time before interest rates would reach their anticipated long-term level.10
In the same statement, the FOMC announced that it expected to begin its “balance sheet normalization program” relatively soon. In other words, to start reducing the size of its balance sheet.
It intends to do this by ending its practice of replacing securities as they mature. This will naturally shrink the balance sheet, but over a very long period of time.11 The Fed’s decision to use such a passive approach arose from concerns that a large program of asset sales could disrupt markets and cause high volatility in asset prices and exchange rates.12
As Gavyn Davies’ Financial Times article explains, the glacial pace of balance sheet unwinding means that the effect on the dollar exchange rate is likely to be quite different from the effect of QE.13 Firstly, the Fed is unlikely to sell its entire holdings. Public demand for dollars has risen and is projected to keep on rising, which implies that the Fed balance sheet will need to be larger in future than was the case prior to the financial crisis.14 Additionally, there has been a fundamental change to the way in which monetary policy is conducted, which if retained for the future will mean the Fed’s balance sheet must remain permanently inflated.
To understand this, let’s look at how monetary policy works in “normal” times. The Fed Funds rate is the rate at which banks lend reserves to each other overnight to meet reserve shortfalls. The Fed influences this rate by “open market operations,” in which it buys or sells financial assets to adjust the total amount of reserves in the system. Selling financial assets reduces the reserves in the system, making them scarcer and therefore putting upwards pressure on the interest rate banks will charge for lending them to other banks: conversely, buying financial assets increases the quantity of reserves in the system, reducing banks’ need to borrow from each other and therefore putting downwards pressure on the Fed Funds rate.
When there are excess reserves in the system, however, the natural Fed Funds rate is zero. To keep the Fed Funds rate above zero, the Fed pays interest on “excess reserves” (reserves in excess of the minimum that regulators require banks to keep). Banks with excess reserves can place them on deposit at the Fed at the “interest rate on excess reserves” (IOER rate) rather than trying to find another bank to take them. Any bank that needs to borrow reserves must therefore borrow at the IOER rate or above. Thus, the IOER rate acts as a floor for the Fed Funds rate: the higher the IOER rate, the higher the Fed Funds rate will be.15
Now the Fed has started to raise interest rates, but there are still excess reserves in the system because the Fed has not yet started to reduce its asset holdings. So, the Fed is raising the Fed Funds rate by progressively lifting the IOER rate.16
It would be tempting to reduce the Fed’s balance sheet to the point where banks become short of reserves and start lending to each other at the Fed Funds rate again. But the very long pace of adjustment means that the “floor” system promises to remain in place for years or decades to come. It may simply prove impractical to replace it.
Davies’ article also argues that the Fed will announce the path for balance sheet reduction well in advance and will offset it with interest rate policy to ensure that there are no nasty shocks for businesses and investors.17 And if the economy were to weaken, the FOMC would halt balance sheet reduction, or even reverse it.18
Such a cautious and limited approach to unwinding the Fed’s balance sheet suggests that there might be little or no effect on the dollar exchange rate apart from natural appreciation as the economy strengthens.
Plans for unwinding the Fed’s balance sheet have been carefully constructed to avoid causing volatility in exchange rates. The dollar exchange rate should simply appreciate gently assuming the U.S. economy strengthens. However, as with interest rate rises, this will depend on the outlook for the economy. If the economy weakens suddenly, then the dollar exchange rate could fall even though the Fed’s balance sheet is shrinking.
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. “What were the Federal Reserve’s Large Scale Asset Purchases?,” Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/faqs/what-were-the-federal-reserves-large-scale-asset-purchases.htm
2. “Unconventional Monetary Policy and Cross-Border Spillovers,” Lael Brainard, Board of Governors of the Federal Reserve; https://www.federalreserve.gov/newsevents/speech/brainard20151106a.htm
3. “Trade weighted U.S. dollar index: broad,” St. Louis Federal Reserve Economic Data (FRED); https://fred.stlouisfed.org/series/TWEXB
4. “The consequences of shrinking the Fed’s balance sheet,” Financial Times; https://www.ft.com/content/828169e8-8902-3d5a-903d-586bf22cc35c
5. “System Open Market Account Holdings,” Federal Reserve Bank of New York (accessed July 19, 2017);1. https://www.newyorkfed.org/markets/soma/sysopen_accholdings.html
6. “Dollar falls to lowest level since Trump election,” Financial Times; https://www.ft.com/content/0459a8c4-4a61-11e7-a3f4-c742b9791d43
7. Consumer Price Index, St. Louis Federal Reserve Economic Data (FRED); https://fred.stlouisfed.org/series/CPIAUCSL#0
8. “Employment situation June 2017,” Bureau of Labor Statistics; https://www.bls.gov/news.release/empsit.nr0.htm
9. “World Economic Outlook,” International Monetary Fund; https://www.imf.org/en/Publications/WEO/Issues/2017/07/07/world-economic-outlook-update-july-2017
10. “Federal Reserve issues FOMC statement,” Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/newsevents/pressreleases/monetary20170726a.htm
11. “Federal Reserve issues FOMC statement on policy normalization principles and plans,” Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/newsevents/pressreleases/monetary20140917c.htm
12. “Minutes of the Federal Open Market Committee, March 14-15, 2017,” Federal Open Market Committee; https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170315.pdf
13. “The consequences of shrinking the Fed’s balance sheet,” Financial Times; https://www.ft.com/content/828169e8-8902-3d5a-903d-586bf22cc35c
14. “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/
15. “Understanding the Permanent Floor,” New Economic Perspectives; http://neweconomicperspectives.org/2013/01/understanding-the-permanent-floor-an-important-inconsistency-in-neoclassical-monetary-economics.html
16. “Interest on required reserve balances and excess balances,” Board of Governors of the Federal Reserve System; https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
17. “The consequences of shrinking the Fed’s balance sheet,” Financial Times; https://www.ft.com/content/828169e8-8902-3d5a-903d-586bf22cc35c
18. “Minutes of the Federal Open Market Committee, March 14-15, 2017,” Federal Open Market Committee; https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170315.pdf