Strong Dollar in Word, Benign Neglect in Deed

The disappointing May employment data caught the market wrong-footed. The pricing of the July Fed funds futures contract had implied almost a 75% chance of a 25 bp hike later this month prior to the data and the combination of weaker than expected payroll growth and a moderate rise in hourly earnings have seen the odds fall toward 40%. As one would expect, this has weighed on the US dollar. The euro rose above $1.2940 to reach its highest level since May 15 when the high for the year was recorded just above $1.2970. The dollar has generally fared batter against the yen, but it did retreat to its lowest level since May 23, when the greenback dropped briefly below the JPY111 level.

The risk is that the market is exaggerating the significance of the employment report on the FOMC’s rate decision at the June 28-29 meeting. Fed officials have made it abundantly clear that the trajectory of policy is data dependent. That is fine and good for as far as that goes, but the problem is the US reports data nearly every day. Surely not all the data is of equal importance. Generally speaking US data can be pigeon-holed into two categories: economic activity and prices.

Reports covering the real economy are been unequivocal. Economic activity is moderating from the heady 5.3% pace in Q1. The May employment report simply confirms what we have already known from various other reports, though it should still set the tone for economic data in the coming weeks. How much moderation to expect? Consider that since the monetary tightening cycle began in mid-2004, the US economy has recorded average quarterly growth (at an annualized pace) of about 3.6%. The Fed expects the economy to slow to below this pace and there is little reason to doubt that. The slow down from the 5.3% pace to something closer to 3% may feel bad, but 3% growth is still respectable and such growth would still be sufficient to absorb some of the remaining slack in the economy.

Reports covering prices have also been unequivocal. Price pressures are building. Inflation data are of two kinds: actually price changes and expectations, but both are telling essentially the same story. Consider the recent news. The prices paid component of the ISM manufacturing survey rose to 77.0 in May, a seven month high, after a 71.5 reading in April. The May jobs report did show a slight 0.1% increase in average hourly earnings, but the year-over-year pace remains lofty at 3.7%, only outstripped once since September 2001 and that was in April (when the pace stood at 3.8%). The deflator of core personal consumption expenditures, the Fed’s preferred inflation measure rose to 2.1% in April. While this is only slightly above the 1-2% “comfort zone” (implicit definition of price stability), it is the highest reading since March 2005 and appears to enjoy some momentum. Lastly, consider that US consumer inflation rose at a 5.1% annualized rate in the first four months of this year, which is the fastest pace since 1990. More than actual inflation, Federal Reserve officials are sensitive to inflation expectations.

Arguably inflation expectations are a little more difficult to measure than actual inflation, but there are some indications. One such measure that the Fed has cited in the past is from a University of Michigan survey. The May report found expectations of inflation over the next 12 months stood at 4% up from 3.3% in April. Other indicators of inflation expectations may be being distorted by the three week decline in US interest rates, which may be a function of weakening of the stock market, the pullback in the prices of many commodities, and the unwinding of some structural trades. Over the past three weeks, the 10-year Treasury yield has fallen 20 bp from the 4-year high reached on May 15th of 5.2%. The yield on the two year note peaked on the last day of May at 5.03%. In reaction to the disappointing jobs data, the yield decline 10 bp, the biggest single day decline since last Aug, in response to concerns about the impact of Hurricane Katrina.

The challenge is that the economic cycle and the inflation cycle are not in lockstep. While this might be a challenge for any Federal Reserve chairman, it is particularly acute for Bernanke given his short tenure at the helm. But it is not simply that Bernanke is a rookie chairman, it is also what he has said. In particular, his comments in late April to Congress that the Fed could pause even if the risks were not symmetrical encouraged investors and speculators to question his anit-inflation resolve. There are many observers who now argue that investors are beginning to demand a “Bernanke premium” for investing in US bonds. Even though such arguments seem a bit exaggerated, there does seem to be a kernel of truth. We suspect if there was truly a crisis of confidence in the Fed, bond yields would be much higher and the yield curve much steeper.

Nevertheless, the bond vigilantes may be rightfully concerned that if the Fed pauses now that it would be slipping behind the inflation curve. The May FOMC minutes did recognize the inflation risks posed by the weaker dollar, but the discussion did not appear to go far enough. It is not simply that a weaker dollar may boost import prices.

Rather, the depreciation of the dollar since early spring has effectively offset or taken back at least 50 bp worth of Fed tightening. Therefore, the Fed needs to raise interest rates to restore monetary conditions to what they were earlier this year. If it fails to do so, the Federal Reserve will complicate its future tasks and risk the market doing it for them through selling off US assets.

If the market is not giving the new Chairman the kind of honeymoon he might have wished for, market participants and observers seemed to be tripping over themselves to praise the new Treasury Secretary designate, Henry Paulson. The market likes one of their own for the post. Treasury Secretaries that come from Wall Street have generally been good for the US dollar and US assets in general. It recalls favorably the first Reagan term with Donald Regan (Merrill Lynch) who was at the helm for the early 1980s equity and dollar rally. Even the Republicans on Wall Street seemed to respect, if not like, Robert Rubin (Goldman Sachs). The dollar and US shares rallied on his watch.

That said, there are several reasons that warn that Paulson may not have the same good fortune as his Wall Street predecessors at the Treasury. First, the Bush Administration suffers from a terribly low public approval rating. Many surveys suggest that as low as the President’s support is, the Vice Preisdent’s is even lower. This may limit Paulson’s degrees of freedom, even if he had strong mandate from the President. This raises the second potential constraint. Economic policy in this Administration is seen to be orchestrated from the White House itself not Treasury. Although President Bush indicated that Paulson will be his primary economic advisor, it is not immediately clear how this will be operationalized. Surely Bush intimated the same thing to his first Treasury Secretary Paul O’Neill. Given that next year’s budget is done, the international position has been staked out in the G7/IMF statement and in the recent report on the currency market (no China is not technically a manipulator of the currency market) and Bush’’s tax cuts have been extended, where is there space for Paulson’s expertise to shine?

Indeed, even though Paulson would be the first Treasury Secretary that will serve under Bush that came from Wall Street, in a couple of ways Paulson is very much like other Bush appointees. First, he is a loyal Republican. He served in Nixon’s government and has been a significant financial contributor. Second, and arguably more telling, Paulson has a close contact in the White House in the form of Josh Bolten, a former colleague at Goldman Sachs. Reports suggest Bolten has been pushing for his friend since he became the Chief of Staff earlier this spring. When other countries do it, we accuse them of “crony capitalism” when the US does it is called networking. This is also par for the course for this Administration. While there are countless examples, consider that until she left recently for maternity leave, Dick Cheney’s daughter Elizabeth was the principal deputy assistant secretary of state for the Near-East, a position that the respected journalist Elizabeth Drew noted, “does not require Senate confirmation and from which people on Capitol Hill saw her as effectively in charge of the State Department’s Middle East bureau.”

Much has been made of Paulson experience with China. However, it is simply naïve to think the reason that China has not capitulated to numerous (and sometimes conflicting) US demands is that the right person did not ask in the right way. China’s position when it comes to trade, currency, North Korea, Iran, Taiwan and its arms build up, is a function of how the ruling elite perceive their national self-interest. The Bush Administration and investors who expect a significant break through with China will likely be sorely disappointed. China will move at its own speed regardless of who is the US Secretary of the Treasury.

Similarly, US dollar policy is unlikely to change. Paulson is likely to follow the more than 10-year old declaratory policy of saying that a strong dollar is in US interest. But, given the lack of political will (in the US and elsewhere) to make the structural reforms that are understood as necessary, the currency market will have to bear the burden of the adjustment process. Strong dollar in word, benign neglect in deed.
Strong Dollar in Word, Benign Neglect in Deed Strong Dollar in Word, Benign Neglect in Deed Reviewed by magonomics on June 02, 2006 Rating: 5
Powered by Blogger.