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Don961:  The calm before the exchange rate storm?

Written by: Kenneth Rogoff

CAMBRIDGE – As alternative assets such as gold and bitcoin flourish in times of the pandemic, some leading economists are expecting a sharp decline in the price of the US dollar. It is possible. But so far, despite the floundering management of the pandemic by the US government, the massive deficit spending to provide economic relief from the disaster, and the monetary easing that Federal Reserve Chairman Jerome Powell said had “crossed many red lines”, basic dollar exchange rates remained calm on About suspiciously, it was not even affected much by the drama of the ongoing elections.

Perhaps traders and journalists have exhausted themselves with the daily troubles of the green currency. Those of us who are interested in studying longer-term trends in exchange rates treat the matter as unjustified confusion.

We do not deny that the value of the euro has increased against the dollar by about 6% so far in 2020, but it is a negligible percentage compared to the violent fluctuations that occurred in the wake of the 2008 financial crisis, when the value of the dollar fluctuated between 1.58 and 1.07 against the euro.

Likewise, the dollar’s exchange rate almost did not move against the yen during the pandemic, while the rate of the yen fluctuated between 90 and 123 against the dollar during the Great Recession. If we look at the dollar exchange rate index on a large scale compared to all the trading partners of the United States, we will find that it is currently stable at the same level it was in about mid-February.

Such stability is surprising, especially given the fact that the exchange rate volatility increases dramatically, usually during American recessions. As I discussed in recent research with Ethan Elzitzky, a professor at the London School of Economics, and Carmen Reinhart, the World Bank’s chief economist, the muted reaction to fundamental exchange rates was one of the major macroeconomic mysteries the pandemic has created.

Economists have known for decades how difficult it can be to explain currency movements. Nevertheless, the strong assumption in such a situation is that exchange rates must change violently in an environment dominated by macroeconomic ambiguity greater than what most of us have seen in their lives.

But even as a second wave of the Covid-19 virus for Europe caught fire, the euro has only fallen marginally – and that is only a drop in the ocean when we talk about volatility in asset prices. As for the talks about the fiscal stimulus plan in the United States, they rotate one day and stop the next. Although the uncertainty surrounding the US elections is moving towards a solution, there are more huge battles ahead over politics for Americans. So far, however, any reaction regarding exchange rates has been relatively limited.

Nobody knows for sure what could have prevented currency movements from getting out of hand. But possible explanations include the prevalence and recurrence of shocks, the generosity of the US Federal Reserve in providing dollar swap lines, and the massive financial backlash by governments around the world. But the most logical reason is the paralysis of traditional monetary policy, as official interest rates in all major central banks stand at or near the lowest actual level (about zero), while senior economic forecasters expect those rates to remain in place for many years, even according to an optimistic scenario. To grow.

Had it not been for the use of near-zero minimums, most central banks today would have set interest rates much lower than zero, for example reaching minus 3 or 4%, which suggests that even if the economy improves, there may be a long time for policy makers to prepare for “take off “From the zero zone, raising interest rates to positive territory.

Interest rates are not the only potential driver for exchange rates. There are other important factors as well, such as trade balances and risk. There is no doubt that central banks are involved in various quasi-financial activities such as quantitative easing.

But with exchange rates essentially stabilizing in a frigid, freezing region, perhaps the biggest source of ambiguity has vanished. In fact, as I explained with Elzitsky and Reinhart, the potential for core exchange rate volatility was diminishing little by little before the pandemic, especially as one central bank after another approached the zero bound, followed by the Covid-19 pandemic, and the sharp drop in interest rates took hold.

However, the current recession will not last forever. Thanks to controlling relatively acceptable inflation rates, the true value of the broad-based dollar index has been on the rise for nearly a decade, and is likely to partially rebound at some point to the average rate (as it did at the turn of the third millennium). Although Europe is currently affected more than the United States by the second wave of the virus, this model may reverse with the onset of winter, especially if the post-election transition period causes paralysis of health and macroeconomic policies.

Although the United States has so far enjoyed tremendous capacity to provide much-needed disaster relief to hard-hit workers and small businesses, the growing share of US public debt and corporate debt in global markets indicates vulnerabilities that may persist for a long time.

To simplify the matter, I would say: There is a fundamental contradiction that will emerge in the long run between the continuous increase in the share of US debt in global markets and the continuous decline in the share of US output in the global economy.

(The International Monetary Fund expects that the size of the Chinese economy will increase by 10% by the end of 2021 compared to its size at the end of 2019). The balance between the two sides eventually led to the collapse of the Bretton Woods system of fixed exchange rates that emerged after the World War, a decade after Robert Triffin, a professor of economics at Yale University, first alerted the dilemma in the early 1960s.

Certainly, there is a possibility for a greater appreciation in the value of the dollar in the near to medium terms, especially if other waves of Covid-19 stress the financial markets and trigger waves of escapes to safety.

Putting aside the issue of exchange-rate ambiguity, the possibility remains that the dollar will remain the king until 2030. But it is worth remembering that economic shocks, like the one we are experiencing now, are often proving to be painful turning points.

Kenneth Rogoff, a former chief economist at the International Monetary Fund, and now professor of economics and public policy at Harvard University, is among his books: This Time Is Different: Eight Centuries of Financial Foolishness, and the book: The Monetary Curse.