Backlash from foreign governments to the restart of large-scale asset purchases (LSAPs, also referred to as QE2) has been intense. Concerns include the charge that the Fed is engaged in “competitive devaluation,” and that it is feeding asset bubbles around the world.

• An article published earlier this week in the Wall Street Journal was a “Who’s Who” of the backlash crowd: This includes key government figures in Brazil, China, Germany, and Russia—the list has since expanded to include others, such as Turkey. To my knowledge, however, major foreign central bank officials have not joined in.[1]
• The government officials are all are disturbed that the FOMC is not thinking about their interests when it sets policy. In effect, they are saying that the Fed is the central bank of the world, given the role of the dollar as a reserve currency.
• Foreign government officials are also lecturing the Fed about the outlook, suggesting that the FOMC is “misreading” the strength of the recovery and is “over-reacting.”
• They are also sounding off a theme of the hawks on the FOMC: They are saying that the asset purchase program “won’t work.”
• Frankly, we never knew that foreign officials were so knowledgeable about the U.S. outlook and the effects of U.S. monetary policy!

How does the exchange rate affect monetary policy? How will the foreign backlash affect monetary policy going forward?

• We have not changed our firmly-held view that the FOMC has no dollar policy; it has no target for the dollar, just as it has no target for equity valuations. Dollar policy is the realm of the Treasury. The foreign backlash will not dissuade the Committee from pursuing what it sees as appropriate policy.
• For the most part, the dollar has two roles with respect to monetary policy: First, it is part of the transmission mechanism, part of how monetary policy affects the economy. Second, to the extent that the dollar moves independently of monetary policy, it is like any other variable: The FOMC takes actual and projected changes in exchange rates into account in its forecast and responds accordingly.
• There are two circumstances (discussed below) under which the dollar would take more of a center stage in FOMC deliberations: (i) a “free fall” in the dollar and (ii) a tighter and more intense link between the dollar and commodity prices in a context of a faster pass-through from commodity prices to long-term inflation expectations and core inflation.

Is the FOMC engaged in competitive devaluation? Nonsense!

• Any country with an open economy and flexible exchange rates will see its currency depreciate when it eases monetary policy conditions (unless others follow with the same policy). Indeed, the resulting boost to net exports is an important part of the transmission mechanism between monetary policy and economic activity.
• Competitive devaluation happens when a country with a fixed exchange rate unilaterally lowers that rate or when a country with a floating rate intervenes to try to depreciate its currency (or avoid appreciation), “robbing” demand from others.
• Interestingly, some of the countries now criticizing the Fed are the same ones that routinely intervene in the foreign exchange market in order to manipulate the value of their currencies.

The Fed’s foreign critics are effectively saying that the FOMC should not carry out monetary policy in the U.S. without considering the effect on foreign economies and, perhaps, before consulting with other governments. Again, this is total nonsense.

• How much sympathy should the Fed have for this criticism from officials in countries with independent central banks, like those in the euro area? Absolutely none!
• Take Germany as an example: It is objecting because the euro is appreciating, putting pressure on German exports, slowing German aggregate demand, and lowering German inflation further.
• If the German government doesn’t like the exchange-rate implications of further easing by the Fed, it should be calling for additional easing by the ECB and strongly opposing the ECB’s leaning toward an early exit from its relatively accommodative policies. (Note that Jean Claude Trichet, President of the ECB, has, appropriately, not commented on Fed policy.) But, of course, the ECB is just following “Bundesbank” monetary policy. The German government should be rejoicing!
• The German authorities might say that it cannot win the day at the ECB. In response, Chairman Bernanke should say: Too bad! The Chairman didn’t tell Germany to join the euro area. (Did he?)

What about the Asian economies, including China, which complain that the Fed is contributing to asset bubbles around the world?

• The real question we have to ask is why FOMC policy is affecting asset prices abroad: The answer is that the Asian economies competitively intervene in their exchange markets to manipulate the value of their currencies! As a result, they cannot have independent central banks. They are, therefore, importing U.S. monetary policy. Is that policy right for them? Hell no!
• How should the FOMC respond to these countries? The Committee should say: You have no one to blame but yourselves. Hasn’t the U.S. government already advised you to float your currencies and not intervene? With respect to China, by the way, wouldn’t an appreciation of the renminbi be just what the doctor ordered? Isn’t just what’s needed to restrain inflation and aggregate demand?
• What should Asia be saying to the Fed? Thank you! Please keep the U.S. economy out of a recession that could greatly threaten the global recovery.

Does the FOMC ever worry about the dollar? Yes, under two circumstances:

• A Dollar Collapse: If the dollar were to go into “free fall” (we will know it when we see it), the FOMC would face an enormous challenge because that would be catastrophic for the U.S. and foreign economies alike. There would be chaos in financial markets around the world. This is a nightmare scenario for the Fed, but a tail risk. Here, we expect that the FOMC would have to be part of the policy response to stabilize the dollar. Free fall, however, is much more likely as a result of continued fiscal irresponsibility in the U.S.
• The Dollar-Commodities-Inflation Nexus: The FOMC likely worries about the recent seemingly more intense relationship between the dollar and commodity prices. The consequences depend on the degree to which commodity prices are passed through to core inflation. In any case, a sharp and persistent rise in commodity prices could raise concern about an unhinging of long-term inflation expectations, which, in turn, could affect monetary policy. Today, however, the main driver of rising commodity prices, we believe, is supply and demand, especially soaring demand by Asian economies.

For all the talk of a Fed bent on devaluing the dollar, what we actually have is a Fed that has been more cautious than we had anticipated.

• The $600-billion asset purchase program that the FOMC announced last week will take place at a slightly slower pace than we had anticipated.[2]
• In addition, the remainder of the FOMC announcement may be consistent with a smaller amount of cumulative purchases than we previously thought.
• What the Fed did, however, was buy time for the economy to strengthen on its own, and, perhaps, remove the pressure to ease more aggressively. This “quiet time” should silence the backlashers, at least for a few months.

This is from a longer commentary, published on November 12, 2010, that is part of MA's Monetary Policy Insights Service.


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