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.