Plaza Accord or Currency War Playbook?

Citi GPS Opinion Article

11 July 2019 – The external value of the U.S. dollar is again under scrutiny, not least by President Trump and some of his economic advisers. The President has criticized Mario Draghi, President of the ECB, for talking down the euro with dovish remarks about possible future expansionary monetary policy options available to the ECB, including future rate cuts and the resumption of asset purchases. He has criticized Jerome Powell, Chair of the Federal Reserve Board, for strengthening the U.S. dollar by being insufficiently dovish in word and deed.

This raises the question whether the U.S. dollar is indeed overvalued and, if so, whether there is a case for a coordinated attempt by the leading industrial countries (including China) to engage in a concerted intervention to bring down the external value of the dollar. Is there a case for a new Plaza Accord? Figure 1 shows a measure of the U.S. real exchange rate for goods since 1973.

The Plaza Accord between what was then known as the G5 nations (France, West Germany, Japan, the U.K., and the U.S.) was a joint agreement, signed on September 22, 1985, to use foreign exchange (FX) market intervention and complementary national monetary and fiscal policies to weaken the U.S. dollar relative to the Japanese Yen and the German D-mark and thus to reduce the trade surpluses of Japan and Germany vis-à-vis the U.S. Between October 1978 and March 1985, the 1985 the real exchange rate of the dollar (as measured in Figure 1 by the Real Trade Weighted U.S. Dollar Index: Broad, Goods) appreciated by almost 60 percent (from 82.5 to 131.6). The fundamental drivers on the U.S. side were very tight monetary policy (the Volcker disinflation) and loose fiscal policy under Reagan.

Following the Accord, the U.S. dollar weakened to such an extent that on February 22, 1987, the G5 plus Canada signed the Louvre Accord aimed at halting the persistent decline of the U.S. dollar. The dollar real exchange rate had fallen to 101.7 by February 1987 and continued to decline for a year following the Louvre Accord before settling down in the low to mid-90s by 1988. West Germany’s trade surplus with the U.S. shrank. Japan’s did not.

What is different today? First, by the standards of the overvaluation of the U.S. dollar in 1985, the dollar appreciation is rather small beer: the Real Trade Weighted U.S. dollar index in Figure 1 stood at 101.1 in June 2019, a significant strengthening relative to the low to mid-80s seen from 2011 through 2013 but still far below the Plaza Accord levels. A similar story is told by the Real Broad Effective Exchange Rate for the U.S., calculated as weighted averages of bilateral exchange rates adjusted by relative consumer prices, which by May 2019 had strengthened by about 20 percent relative to its value over the period 2011-2013.1

A second difference between today’s situation and the Plaza Accord is that in 1985 every G5 member, not just the U.S., was concerned about the excessive strength of the U.S. dollar and stood ready to act and intervene in a coordinated way. Today only President Trump and his team decry the excessive strength of the U.S. dollar. This is a one-sided Plaza at best — another chapter in the currency wars playbook, with the U.S. President trying to tweet the dollar down and hinting at other unconventional measures to achieve that objective.
A third difference is the underlying policy mix. Back then, Fed Chair Volcker was undertaking a policy to bring inflation down from double digits. Fed Chair Powell is trying to get inflation up.

Is the U.S. dollar strength surprising?

Textbook economics suggests that when the exchange rate is market-determined and there is a high degree of international capital mobility, a country’s exchange rate should strengthen if (1) its monetary policy is relatively restrictive, (2) its fiscal policy is relatively expansionary, and (3) private domestic demand is relatively robust/buoyant. The U.S. ticks all three boxes. With regards to monetary policy, the markets now anticipate two or more Fed rate cuts during the current year, but as of now nothing has been delivered. On fiscal policy, the effects of the pro-cyclical fiscal stimulus of 2018 are still making themselves felt. As regards relative buoyancy of private demand, U.S. household demand (which accounts for 68 percent of GDP) appears materially more robust than consumption in most other advanced economies. The recent healthy payroll data are consistent with this outperformance.

Another factor underlying dollar strength is the trade war. Imposing tariffs on imports can yield a partially offsetting strengthening of the currency of the imposing country. In addition, the larger domestic market which is relatively more services-oriented implies that the trade wars are negatively impacting growth abroad more than in the U.S. Thus augmenting the dollar advantage Trump’s trade policy is therefore one of the drivers of the dollar’s strength, which makes a sympathetic response by America’s trading partners to a request for coordinated intervention to weaken the U.S. dollar rather less likely.

On top of these four standard macroeconomic drivers of exchange rate strength, the unique role of the U.S. dollar as the world’s leading reserve currency means that in periods of fear and uncertainty, there will be safe haven inflows into U.S. dollar assets, which will strengthen the currency. This is the case even if the source of the uncertainty is U.S. policy. This means it is not just the actual imposition of tariffs strengthening the currency but, in addition, the risk and uncertainty about the future evolution of the trade conflicts and wider tech wars will strengthen the U.S. dollar through safe haven effects.

So altogether there are five good, fundamental reasons why the U.S. dollar should be strong. Given these fundamentals, Plaza-style foreign exchange market intervention would likely be ineffective. And the policies that would make such intervention effective would necessarily be actual or expected changes in the economic policy fundamentals and other fundamentals that have driven up the external valuation of the U.S. dollar.

Unlike the multilateral, mutually supportive interventions of the Plaza Accord, any intervention to drive the U.S. dollar down now would likely be a U.S.-only affair. The logistics could also be interesting. The U.S., like a number of other countries, considers the exchange rate and foreign exchange intervention to be the domain of the Treasury, although the implementation of foreign exchange market interventions is assigned to the central bank. In the words of the New York Fed; “The Department of the Treasury and the Federal Reserve, which are the U.S. monetary authorities, occasionally intervene in the foreign exchange (FX) market to counter disorderly market conditions”, … “The Treasury, in consultation with the Federal Reserve System, has responsibility for setting U.S. exchange rate policy, while the Federal Reserve Bank New York is responsible for executing FX intervention.”2 and “The foreign currencies that are used to intervene usually come equally from Federal Reserve holdings and the Exchange Stabilization Fund of the Treasury.” It is unlikely that, under current conditions, the Fed would consider foreign exchange market interventions to drive down the value of the U.S. dollar to be appropriate. The President’s concern is not disorderly conditions in the foreign exchange markets but what he considers to be the excessive strength of the U.S. dollar. That then raises the interesting political and institutional issue of whether an operationally independent Fed can be instructed by the U.S. Treasury to act in a manner the Fed deems inappropriate. To be continued …

1 BIS, Real Broad Effective Exchange Rate for United States, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RBUSBIS, July 10, 2019.
2 Federal Reserve Bank of New York, Fedpoint U.S. Foreign Exchange Intervention,https://www.newyorkfed.org/aboutthefed/fedpoint/fed44.html