Thursday, February 9, 2017

To what extent can Trump trash the dollar?

Donald Trump doesn't like the strong dollar, but is there anything he can do about it?

Last month Donald Trump told the Wall Street Journal that American companies can’t compete "because our currency is too strong. And it’s killing us...” Trump's dislike of the strong dollar doesn't surprise me. I've known a few mercantilists over the years, and all of them have always been keen on trashing their home currency, the idea being that with a weaker currency domestic manufacturers will enjoy a shot to the arm. This in turn stems from the antiquated (and very wrong) idea that manufacturing is somehow the most important activity an economy can be engaged in.

Tweeting about one's desire for a weak dollar is one thing, but are there any actual levers Trump can pull on to affect the exchange rate?

U.S. exchange rate interventions are rare these days, with only two occurring in the last twenty years. In September 2000 U.S. monetary authorities intervened with other central banks to support the euro, and in March 2011 they bought yen after the earthquake that rocked Japan on March 11. The main concern of modern central bankers is their inflation target. To hit this target, interest rates have become the preferred tool. Unlike the gold standard or Bretton Woods era, the exchange rate has little role to play in this story, either as a target of monetary policy or as a tool.

Past efforts to fiddle with the dollar's exchange rate have typically been joint affairs taken on by the Federal Reserve and the Treasury. It makes sense to have the central bank as a partner because a central banker has the ability to create as much money as necessary in order to drive the exchange rate down. If Trump were to try to go it alone, he'd first have to go through the hoops of raising taxes or issuing bonds in order to get the requisite dollars to sell, this being a much weaker lever compared to the Fed's infinitely-powerful printing presses.

If Trump were to request that the Fed weaken the dollar, could Fed Chair Janet Yellen refuse to co-operate? The Fed could certainly dig in its heels. Anna Schwartz, channelling former Fed chairman Paul Volcker, notes that "the Treasury does not have authority to instruct the Federal Reserve to spend its own money on intervention and to take the attendant risks, and that the Treasury would be reluctant to intervene over strong objections of the Federal  Reserve." This Peterson Institute publication provides an actual example of heel-digging. In 1990, most of the members of the FOMC were against continued purchases of Deutschmark and yen by George Bush, with three members voting against raising warehousing limits (see below for a description of warehousing) from $10 billion to $15 billion. While their push back wasn't enough to carry the day (the warehousing ceiling was increased), presumably it indicates that the Fed has a means for resisting Treasury demands, if not always the guts. The Fed has at times been dragged along as an "unwillingly participating" in Treasury-initiated interventions because—as Michael Bordo, Anna Schwartz, and Owen Humpage put it—appearing not to cooperate would "raise market uncertainty and could sabotage the operation's chance for success."

Given these conflicting views about the hierarchy between Fed and Treasury, when push comes to shove I don't know who would win out in a conflict between the two institutions. What seems sure is that any effort by Trump to arm twist the Fed into weakening the dollar would be controversial. If the Fed were to get its way, expect to hear outrage about the trampling of democracy by an "inbred" technocracy of academic economists. On the other hand, if Trump were to get his way he would be denounced for threatening the Fed's ability to keep inflation in check. As Goodfriend and Broaddus put it in this paper, Fed participation in Treasury-led foreign exchange operations has the potential to confuse the public as to whether monetary policy is supposed to support short-term exchange rate objectives or longer-term anti-inflationary objectives. Which is why Goodfriend and Broaddus advocate legislation that enforces a complete separation of the Fed from the Treasury's forex operations.

Let's imagine a Yellen-led Fed successfully rebuffs Trump. Does the President have any other levers to influence the dollar?

Enter the Exchange Stabilization Fund, or ESF. When the Fed and Treasury partner to intervene in foreign exchange markets, it has always been the ESF that has been responsible for the Treasury's contribution to the intervention. This obscure account, managed by the Treasury Secretary, is entirely self-funding. This means that, unlike the Treasury's other expenditures, spending from the ESF is excluded from the congressional appropriation process. Only the President, not Congress, has the authority to review the Treasury’s decisions regarding ESF operations.

The ESF has an odd history. It was established in 1934 by the Gold Reserve Act with $2 billion worth of proceeds derived from the revaluation of the U.S. gold from $20.67 to $35 per ounce. It has been used not only as the Treasury's counterpart to the Fed in exchange interventions, but also as a tool to bailout foreign governments, including a Clinton-led rescue of Mexico in 1995. Courtesy of George Bush and Henry Paulson, the ESF was most recently tasked with guaranteeing U.S. money market mutual funds during the 2008 credit crisis.

As of December 2016, the ESF's assets clock in at a cool $90.4 billion. How much of this might Trump devote to riding down the dollar? Take a look at the ESF's balance sheet and you'll see that of that $90.4, the ESF has $22 billion in U.S. securities. So it could sell $22 billion right now in order to push down the dollar.

Scanning through the rest of the balance sheet, the ESF also owns $50.1 billion IMF special drawing rights, or SDRs. (I wrote about SDRs here). The Treasury has the power to monetize these SDRs by depositing them at the Fed in return for fresh dollars. For the curious, I've snipped the relevant section from the ESF's statements:

To date, $5.2 billion worth of SDRs have been monetized, so presumably that leaves another $45 billion left as firepower. Note that the Fed cannot legally refuse to accept SDRs that have been submitted for monetization.

The ESF also has euros and yen to the tune of ~$19 billion. While it can't sell these currencies in order to weaken the dollar, it can exploit a long tradition with the Fed called "warehousing." If the Treasury Secretary wants the ESF to sell dollars but it lacks the resources to do so, the Fed has typically offered to buy the ESF's forex assets up to a certain warehoused amount in return for dollars, the ESF agreeing to take on the exchange rate risk. Think of this as a repo, securitized loan, or swap. According to the Treasury, this Fed-determined limit is currently $5 billion, although during the 1995 bailout of Mexico the warehouse was temporarily increased to $20 billion. So of the ~$19 billion in yen and euros on the ESF's balance sheet, at least $5 billion could be automatically converted into dollars and sold via the Fed's warehousing facility.

Where does that leave us? $22 + $45 + $5 billion = $72 billion. That's a lot of dollars that the ESF can potentially sell. But would it be enough to have a real impact the exchange rate? Foreign exchange markets are massive. According to the BIS, daily spot trading in U.S dollars averaged $1.4 trillion in April 2016! The ESF seems like a drop in the bucket to me, no? Furthermore, the Fed would become the ESF's biggest enemy in this game. If the ESF were to be successful in pushing down the dollar, this would constitute monetary loosening and would have to be offset by the Fed lest it miss its inflation target. Nor is Congress likely to top up the ESF's firepower, as Russell Green points out here, given the odds of success are low.[1]

Suffice it to say that Trump can certainly score an initial symbolic victory by tasking the ESF to weaken the dollar, but he needs to have the unlimited firepower of the Fed if he wants to do true damage. And that firepower might not be forthcoming, at least as long as Janet Yellen—and not a Trump flunky—is holding the reins.

[1] One exception that Congress might agree to is the obscure $42.22 maneuver.


  1. “The ESF seems like a drop in the bucket to me, no?”

    I’m puzzled you haven’t considered the most straightforward policy, at least in theory, which would be for the ESF to buy foreign exchange – e.g. Euros and yen - funded by Treasury issuance. That puts downward pressure on the dollar FX rate through actual FX transactions. And the balance sheet size of the ESF is not a constraint in that sense – quite the opposite from an operational perspective, as there is no operational limit, assuming the same for debt issuance. The Fed might be in the background with monetary policy that is consistent and even supportive (with QE for example) - or not.

    Your examples seem more oblique, using what is essentially monetary policy with a hope and a prayer it would result in a desired FX effect. But it would seem the expected result from that might be no more potent than whatever regular QE achieves in terms of FX effect.

    I assume the ESF holds Treasuries as a form of operational liquidity protection – i.e. an emergency source of dollars to sell in the event of some foreign crisis that warrants a quick operational source of US dollars for supportive FX intervention. But just selling those Treasuries in the case you consider without buying FX doesn’t do much. From a consolidated balance sheet perspective, those Treasuries are funded by other Treasuries (which isn’t that strange if indeed their purpose is that of liquidity protection for potential FX intervention). Selling them just to put dollars into the government’s cash account at the Fed doesn’t do much for foreign exchange value purposes. In fact, without being used to buy FX, they would seem to be no more than a source of funds in managing the debt program otherwise - i.e. a likely way of paying down the debt on the other side of the consolidated balance sheet, assuming they are not being used to buy FX.

    Similarly, your other examples look like a form of backdoor monetization, where the FX reserves are still kept in house on a consolidated basis. The external effect is along the lines of QE, just using assets already held on the consolidated balance sheet. Again, this won’t do much in terms of a direct FX effect. I’m not sure why the effect on FX would be any more than what comes out of QE in the regular case.

    From an institutional perspective, Treasury has always run the shop in terms of dollar policy. That’s why Fed Chairs are restrained in making statements about the dollar.

    But anything can happen. E.g. the interest rate peg in WWII.

    1. "I’m puzzled you haven’t considered the most straightforward policy, at least in theory, which would be for the ESF to buy foreign exchange – e.g. Euros and yen - funded by Treasury issuance. "

      Well it depends what you mean be straightforward. In a world without politics, I agree with you. However, introducing politics into the equation changes things. If Trump wants to engage in massive fx intervention funded by treasury issuance, that means going through the thorny budgeting/appropriations process involving Congress. A request for a warchest might not survive. The ESF, on the other hand, is quite safe from the political process, in that it is already funded and has little Congressional oversight--so that's why I consider it to be the default option.

      "But just selling those Treasuries in the case you consider without buying FX doesn’t do much. "

      In my head I was imagining that the ESF was selling $22 bln in Treasuries to raise dollars, then buying FX. I don't think I explained that very clearly.

      "Similarly, your other examples look like a form of backdoor monetization, where the FX reserves are still kept in house on a consolidated basis. The external effect is along the lines of QE, just using assets already held on the consolidated balance sheet. Again, this won’t do much in terms of a direct FX effect. I’m not sure why the effect on FX would be any more than what comes out of QE in the regular case."

      The swap of SDRs/forex for Fed reserves is like QE. The next stage is for the ESF to sell those dollars for euros/yen etc, and presumably this should have some effect on the exchange rate, even if only a short term effect.

    2. On the first point, I did say "in theory", with all the coordination that requires.

      Regarding your last two points, I didn't notice reference in the post to the actual purchase of FX in those cases.

    3. Sorry - rereading the post, its clearer now where you were referring to the sale of dollars and purchase of FX.

  2. Here’s something tangentially connected in time and space:

    Back in the day (actually, the Volcker day), I ran the reserve (settlement) position for one of the Canadian commercial banks. The Canadian version of the US ESF was (is?) called the Exchange Fund Account, the EFA. That account played a very interesting role in monetary policy execution. Perhaps it still does. I don’t follow in detail now. But there’s a slight connection with the case you mention for the ESF.

    Back then, especially during the Volcker tightening, the Bank of Canada’s reserve management was by necessity extremely aggressive in targeting short term interest rates. It had to be, given the absolute level of interest rates, and the market’s propensity to speculate on the Bank’s next move and the degree to which the Bank would move. The secular trend in the early 80’s was of course the greatest tightening in monetary policy we’ve ever seen. And there are many potential episodes of interest rate volatility when the rate level is headed generally in the direction of 20 per cent or beyond.

    Anyway, the equivalent of the bank rate back then was driven by the results of the weekly 3 month Treasury bill auction.

    Occasionally, the market would get it wrong in guessing the Bank’s desired level for that 3 month rate - either at auction, or during the week otherwise. There could be periodic bursts of the market either buying or selling bills within the trend, where the market would attempt to drive rates either down, or further up, relative to the Bank of Canada’s desired near term objective. If the market was “wrong” in terms of what the Bank wanted to see, the Bank might intervene aggressively in the bill market, either selling or buying in order to get the message across.

    When it did, the size of the intervention would inevitability have a disproportionate effect on the excess reserve position of the banking system. For example, if the Bank of Canada sold bills to preclude an unwanted market rally in the bills (rates down), the quantity it would sell would drain excess reserves in such a way as to leave the commercial banks hopelessly short of their required reserve levels.

    That would have resulted in an outsized effect on the overnight interest rate especially, unless steps were taken to correct it. It meant that the Bank would have to re-inject reserves back into the system, with the objective of stabilizing the market bill rate at what it had achieved according to its objective in selling bills.

    It would do this by undertaking swapped deposits with the EFA. It would buy FX fully hedged from the EFA on a short dated term basis. That had the effect of replacing the bills it had sold with EFA swaps, and thereby crediting the government’s account at the Bank of Canada. From there, it was easy enough for the Bank to instruct a transfer of those funds to the government’s similar accounts at the commercial banks, which in effect redeposited those funds along with a system reserve credit at the Bank of Canada, meaning that the system excess reserve position would be restored to a normal operating level and the markets could drive on from there at the prevailing post-intervention level of the t bill rate.

    Anyway, thought you might find that summation of old war stories a bit interesting in the context of your subject matter here.

    1. Fascinating. Required reserves, the EFA, and the 3-month rate as a target... all very different from today's system. It's quite something to read how things have changed. I know there must be a reason, but I find it quite odd that the market had to guess the BoC's desired level for 3-month bills. Any idea why the BoC wouldn't have just announced it?

    2. At the time, our own bank (one of the largest) had measurably less than $ 100 billion in assets. Yet required primary reserves (non-interest bearing settlement balances) and secondary reserves (treasury bills and 'day loans’ to dealers) were EACH more than $ 1 billion.

      The relevant rate was the average 3 month t bill rate set at the weekly auction. That was in effect the policy rate. There was obviously no guessing about the result after the result was announced. That result was fixed and known for the rest of the week. But there was considerable guessing before each auction as the bidding process was taking place ("market talk" being an integral part of the culture) and in fact at every time other than that - including post auction and the rest of the week in daily trading, which went on to anticipate the trend into the next week's auction. The auction was a market process, tempered by the excess reserve setting and Bank of Canada intervention at its option at any time - including placing orders in the tender. The Bank of Canada could intervene violently on occasion - before the tender, inside the tender (its own order), after the tender, and at any other time during the week, in order to steer monetary policy with the 3 month t bill rate.

      The more sophisticated players in the money market followed the Bank of Canada's excess reserve setting like a hawk. Weekly statistics were published for each Wednesday, available for interpretation in respect of the Thursday auction. Stats were published for the "spot" Wednesday setting and the "cumulative" average setting for that prior week. Players would interpret that setting for how they viewed the Bank of Canada’s objective for the auction and the bill rate.

      Economics textbooks for the most part had/have no idea just how important the excess reserve setting was for monetary policy implementation in such a system. The US had essentially the same system up until the financial crisis and QE. It was all about how the excess reserve setting steered the interest rate, due to the effect it had directly on the banks and therefore on the rest of the system though propagation.

    3. "I find it quite odd that the market had to guess the BoC's desired level for 3-month bills. Any idea why the BoC wouldn't have just announced it?"

      I'm probably not explaining this very well - just dumping some ancient history (which I think is interesting) in staccato fashion.

      The weekly Treasury bill auction was very much a competitive process among private money market players. They would bid for their own books, and on behalf of clients. Banks and authorized investment dealers. The "guessing" related to aggregate market demand for bills and the expected result for the t bill auction rate, plus expectations for how the Bank of Canada viewed the appropriateness of the general level of rates that might result. As I said, they could intervene at any time - including by bidding at the tender if the demand otherwise was weak. Kind of like an informal, unannounced range of comfort on the Bank's part, relative to where the natural market was driving the rate. A form of ultimate policy control over the bounds of the rate that was determined otherwise by a private sector auction process along with subsequent market trading.

    4. Interesting stuff, JKH. Thanks for that.

  3. Very interesting. Deep thought and analysis. Regards from Argentina

  4. I'm not sure the Treasury is as limited as you say. If the Federal Reserve wanted to preserve an interest rate target, higher short term T-bill rates would force defensive open market operations to stabilize interest rates. Unless you're saying the Federal Reserve would raise rates in response to Treasury auctions, which seems extreme.

    1. I'm not sure I follow. Say the ESF were to spend all of its US$72 billion warchest to weaken the dollar. Would this have an effect on the exchange rate? Commercial banks might temporarily find that they have excess reserves (the overnight rate might be pressured as would the exchange rate) but the Fed would offset these effects, say via open market sales.

  5. The infamous trillion dollar coin would be another way, which is totally in the control of the treasury, right?

    1. Yep, the TDC would be an option. I believe it's in control of the Treasury.