Bi-Weekly Asset Allocation – The Impossible Trinity
By the Confluence Asset Allocation Committee, from November 14, 2022
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The US dollar index hit a 20-year high in September as the greenback appreciated against other global currencies. The rise in the US dollar (USD) began during the post-pandemic recovery. Investors flocked to the greenback for protection as the US economy outperformed its OECD peers. Aggressive policy tightening by the Federal Reserve accelerated the appreciation as US dollar-denominated assets became even more attractive to foreign investors. The strong recovery in USD demand has intensified inflationary pressures globally and could push other countries into recession.
With limited options, central banks and governments have been forced to take extreme measures to prevent their currencies from depreciating. Throughout 2022, investors penalized countries that failed to prioritize fiscal and monetary austerity to contain inflation. Examples include a controversial UK tax plan, stealth quantitative easing by the European Central Bank to maintain sovereign spreads within the eurozone, and Japan’s insistence on yield curve control, which has led to falls in the respective currencies of these countries. The resulting depreciation made dollar-denominated imports more expensive, adding to price pressures. As a result, inflation hit record highs in the eurozone and multi-decade highs in Japan and the UK.
Exchange rate volatility reflects the limits of central banks and governments in the conduct of monetary and fiscal policy. Generally, policymakers have three options when it comes to macroeconomic policy: fixed exchange rates, sovereign central bank policy, or open capital markets. It is impossible to do all three simultaneously because it creates a phenomenon known as the impossible trinity, or political trilemma. In other words, policymakers can opt for a fixed exchange rate only by giving up monetary sovereignty or restricting capital flows.1 After Bretton Woods, most developed economies chose to resolve the situation by opting for floating exchange rates. This choice allowed policy makers to have open capital markets and monetary sovereignty.
The problem with the post-Bretton Woods agreement is that exchange rate levels affect macroeconomic policy objectives. For example, a weak exchange rate can be inflationary, while a strong exchange rate can act as unwanted policy tightening. Thus, extreme movements in exchange rates may become counterproductive to policy objectives and may require a response to alter the trend of an exchange rate. Unfortunately for policymakers, this is where the impossible trinity becomes a problem. During currency crises, emerging countries are known to implement capital controls. However, policymakers in developed economies have generally shied away from such controls, and this reluctance leaves them with only one political option: they must cede their sovereignty. For example, the Bank of England, Bank of Canada and European Central Bank all accelerated their respective pace of rate hikes to keep pace with the Federal Reserve. As a result, the decision to raise rates in line with the Federal Reserve calmed investors’ nerves while hurting economic growth.
Although the impossible trinity describes the problem faced by policy makers in a single country, there are multinational solutions to solve the problem. The Plaza Accord of 1985, the Louvre Accord of 1987, and the Halifax Accord of 1995 are all examples of international cooperation aimed at addressing exchange rate discrepancies. The Plaza Accord was an agreement to address the strength of the dollar. European and Japanese policymakers were reluctant to follow the Federal Reserve’s key rates because the Fed was tackling a serious inflation problem, while other central banks were not facing the same problem2. However, the Fed’s monetary policy led to capital inflows and a rapid appreciation of the dollar. By the mid-1980s, the strong dollar was making US manufacturing uncompetitive and increasing foreign inflation. So in September 1985, the G-5 countries agreed on a coordinated policy response to weaken the dollar. In addition to direct intervention to weaken the dollar, the Fed cut key rates while other countries’ central banks raised key rates. The dollar then reversed its trend.
One could say that the trilemma was not really solved but simply managed during these agreements. In the Louvre Accord, for example, the political actions of the Plaza Accord were reversed to halt the depreciation of the dollar. In a sense, policy makers agreed on a certain policy direction and worked together to achieve a particular goal, namely a change in the trend of exchange rates. Strictly speaking, all central banks have sacrificed their sovereignty to solve an exchange rate problem.
Policymakers therefore resolved the trilemma by allowing exchange rates to float within unspecified limits. When these limits are reached, central bankers are forced to give up their monetary sovereignty until exchange rates adjust to acceptable levels. The question facing the markets now is whether there is a consensus among developed market policymakers that the USD is too strong. So far, this consensus has not emerged, but it is clear that the Japanese authorities are not happy with the yen’s exchange rate but continue to maintain monetary sovereignty through selective interventions. History suggests that such unilateral actions slow the “direction of travel” but do not reverse the trend. If the Europeans are unhappy with the course of the euro, they have not yet made it public. And, with US policymakers primarily concerned with reducing inflation, there is little incentive to pressure the FOMC to cut rates.
This does not mean that there is no collateral damage from the exchange rate markets. The rising USD slashed around $10 billion from corporate profits in the third quarter of 2022. Much of that pain was concentrated in US companies exposed to foreign earnings, particularly in the technology sector. But so far, the weakness of the tech sector has not been problematic enough to warrant a change in policy. Until U.S. policymakers believe they have inflation under control, foreign policymakers must choose between letting their exchange rates weaken further or embracing Federal Reserve monetary policy. Given the persistence of US inflation, the strength of the dollar should continue.
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