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Thursday, June 13, 2019

BIS Research Paper - Ability of the Fed to Create Easy Money is Key to Market Dominance of the US Dollar?

The Bank for International Settlements (BIS) has released this report which examines how Fed policy might impact the dominance of the US Dollar. (see detailed report here). This report is pretty lengthy and technical, but the quote below from the Conclusion section of the report caught my attention. (I added underline for emphasis)

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 Conclusion


"What do our results imply for the future of the dollar? Many explanations of the dominant role of the dollar in the international monetary system feature arguments like inertia, size, network externalities, and market liquidity. All these arguments suggest that changes in the dominance status of a currency occur very slowly. 

By contrast, our results suggest that the dollar can lose its dominance if the expectations that the Federal Reserve is able to stimulate the economy and reduce real debt burdens of firms during global crises actually decline. As this view relies on the beliefs of market participants, this change might occur abruptly."

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My added comments -- There are two points to make here:

1) Please notice that they first point out how that the conventional views of the dominance of the US dollar lend credence to the idea that any change in that dominance will occur slowly over time. This is what we have been reporting here for some time.

2) Next please note that this report seems to suggest virtually the opposite of what the conventional wisdom is on this topic. It says "the dollar can lose its dominance if the expectations that the Federal Reserve is able to stimulate the economy and reduce real debt burdens of firms during global crises actually decline." It appears to say the easy monetary policy actually supports the dominance of the US dollar rather than weakens it as most would assume.

I will leave it to readers to decide if this is a valid analysis of potential market reaction to easy Fed monetary policy designed to "stimulate the economy" during a crisis. It is also interesting to note that their analysis also suggests that "the change might occur abruptly". 

If there is some kind of crisis of confidence surrounding the US dollar during the term of President Trump, we can assume the President will blame the Fed's policies for the crisis (he has already shown he will do that). This report seems to suggest that the blame should fall on a market perception that the Fed is unable to implement an easy money policy to "reduce the real debt burdens of firms" during the crisis. My assumption is that the BIS report is implying that Fed easy money policy would stimulate inflation and therefore reduce the "real debt burden" for entities that are in debt at the time and that markets would perceive that to be the case.

You may ask: But President Trump has been criticizing the Fed for not being easy enough with monetary policy, so doesn't he agree with the BIS report? On the surface that may appear to be the case. However, the BIS report may be suggesting that the Fed should be allowed to tighten now (against the wishes of President Trump) so that when the next crisis arises, they will have the ammunition and credibility to revert back to easy money to "stimulate the economy" during a crisis. The report does not say that, but it is a reasonable inference to make and one we might well see the Fed argue if a dollar crisis does emerge in the future and the President blames the Fed for it.

So we can keep an eye on this to see if this kind of debate does emerge should the US dollar suffer any crisis of confidence during the term of President Trump. If no crisis occurs, all of this is somewhat irrelevant. If a crisis does occur, the blame game will surely ramp up and then these kinds of debates will matter because who the public blames for the crisis will determine who they trust to move forward to fix the crisis. 

At this point, it is fairly easy to predict that President Trump will attempt to blame the Fed if any major crisis does take place during his term. His opponents will certainly will attempt to blame him (tariffs, trade wars, sanctions, etc). This will clearly become a political fight between very powerful entities, so we can expect that it won't be fought politely as if just debating routine policy differences. The people will be forced to pick a side during a heated battle with who will have political power going forward hanging the balance if we get a major crisis. I hope this will not happen because the odds of a good outcome for the general public are low under the current conditions where obtaining and holding political power is viewed as a life or death matter to those engaged in the fight. 

However it could happen. So we need to be alert to the risk and monitor market reaction closely heading into the next US elections. Obviously, a sharply falling stock market, a sharply falling US dollar, and a sharp rise in gold prices are all signals things are not going well. Continued stability in those markets suggests they don't see a major crisis headed our way. Keep in mind though, even markets can get taken by surprise. I doubt the markets anticipated two oil tankers in Hormuz would be hit with an attack before it happened.

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