One would expect anything that former Goldman managing director, and current head of the NY Fed, Bill Dudley says would not come as a surprise to Goldman Sachs, for obvious reasons. However, that was not the case when looking back at a speech delivered by Bill Dudley on Sunday night titled “The U.S. Economic Outlook and the Implications for Monetary Policy.”
In fact, Goldman’s head of FX, Robin Brooks, who has been consistently bullish on the dollar for the past year – was admittedly shocked by what he saw was a remarkably dovish speech from NY Fed President Dudley, which discussed the idea that the Natural Interest Rate, or R-Star, may be around zero. Incidentally, as we have pointed out in the past, the Natural Interest Rate may now well be negative due to the tremendous debt load, which is why as explained before, any attempts to hike rates are likely doomed from the onset.
What a near-zero R* means it that US monetary policy is only moderately accommodative, even as rates are near zero.
But the real punchline in Brooks’ interpretation of what Dudley said is the following:
“More striking, at least in our eyes, was his language on the Dollar, where he essentially made the case that weaker fundamentals elsewhere require a dovish offset from the Fed, to prevent the Dollar from appreciating. This language comes very close to “Dollar targeting,” which the speech was quick to deny, and is a substantial about-face for President Dudley, as Exhibit 1 shows.”
In other wrods, even Goldman now admits that a casual take of what the second most important person in the US Federal Reserve said, is that the US central banks is now openly targeting the dollar, i.e., engaging in currency war even without actively engaging in QE. At least not yet.
What was especially noteworthy about the speech is that it omitted any mention – unlike previous speeches – that monetary stimulus abroad can have offsetting effects on US financial conditions, with rallying stock and bond markets providing some offset to the tightening in financial conditions from the exchange rate. Indeed, seen through the lens of financial conditions, the focus on the Dollar at this stage is hard to reconcile with how much loosening there has been in financial conditions (Exhibit 2). It is an open question whether the speech marks a paradigm shift that moves the Fed in the direction of currency targeting.
But if the Fed is now pushing to devalue the USD regardless of what other central banks are doing, it means a new feedback loop is created, one in which more easing abroad would result in further easing in the US, and so on in a feedback loop:
But if this is the case, the effort to reflate their economies by the ECB and BoJ could be a key casualty, because it requires both central banks to push further and further into unconventional territory, which is turning out to be difficult for both banks.
Said otherwise, full blown currency war with a dose of beggar (and, actually, bugger) thy neighbor. Here is Goldman’s conclusion emphasizing just that.
To underscore the depth of the challenge, Exhibits 3 and 4 show the pace of sequential, month-over-month inflation needed (pink bars) to meet ECB and BoJ core inflation forecasts, respectively. In the case of the ECB, a meaningful pick-up is required to bring core to just one percent in 2016, while a herculean rise is required to meet the BoJ forecast for FY2016 core CPI to reach 0.1 percent, let alone 1.7 percent in FY2017. The risk is that US policy rates that remain low for longer undermine the progress the ECB and BoJ have made, which can’t – ultimately – be in the best interest of the US.
Needless to say, if Goldman’s read on Dudley is correct, it means the global currency wars have just entered into a new stage, one where foreign easing – ostensibly due to economic weakness – leads to further delays by the Fed to hike, leads to more easing aborad, and so on, something which, as Goldman admits, “can’t – ultimately – be in the best interest of the US.”
In the “best interest of the US”, no. But it most certainly is in the best interest of the US stock market, serving to push it to all time highs just as European and Japanese stocks are reeling.
Finally, it also explains why – as Goldman’s assessment starts being appreciated by the market – the dollar is getting crushed.
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