The calm before the exchange-rate storm?

CAMBRIDGE — With alternative assets such as gold and Bitcoin thriving in the pandemic, some top economists are predicting a sharp fall in the US dollar. This could yet happen. But so far, despite inconsistent US management of the pandemic, massive deficit spending for economic catastrophe relief, and monetary easing that Federal Reserve (Fed) Chair Jerome Powell says has “crossed a lot of red lines”, core dollar exchange rates have been eerily calm. Even the ongoing election drama has not had much impact. Traders and journalists may be getting worked up about the greenback’s daily travails, but for those of us who study longer-term exchange-rate trends, their reactions to date amount to much ado about nothing.

To be sure, the euro has appreciated by roughly 6 per cent against the dollar so far in 2020, but that is peanuts compared to the wild gyrations that took place after the 2008 financial crisis, when the dollar fluctuated between $1.58 and $1.07 to the euro. Similarly, the yen-dollar exchange rate has hardly moved during the pandemic, but varied between 90 yen and 123 yen to the dollar in the Great Recession. And a broad dollar exchange-rate index against all US trading partners is currently sitting at roughly its mid-February level.

Such stability is surprising, given that exchange-rate volatility normally rises significantly during US recessions. As Ethan Ilzetzki of the London School of Economics, the World Bank’s Carmen Reinhart, and I discuss in recent research, the muted response of core exchange rates has been one of the pandemic’s major macroeconomic puzzles.

Economists have known for decades that explaining currency movements is extremely difficult. Nevertheless, the overwhelming presumption is that in an environment of greater global macroeconomic uncertainty than most of us have seen in our lifetimes, exchange rates should be shifting wildly. But even as a second wave of COVID-19 has stunned Europe, the euro has fallen only by a few per cent, a drop in the bucket in terms of asset-price volatility. Fiscal stimulus talks in the United States are on one day, off the next. And although America’s election uncertainty is moving toward resolution, more huge policy battles lie ahead. So far, though, any exchange-rate response has been relatively small.

Nobody knows for sure what might be keeping currency movements in check. Possible explanations include common shocks, generous Fed provision of dollar swap lines, and massive government fiscal responses around the world. But the most plausible reason is the paralysis of conventional monetary policy. All major central banks’ policy interest rates are at or near the effective lower bound (around zero), and leading forecasters believe they will remain there for many years, even in an optimistic growth scenario.

If not for the near-zero lower bound, most central banks would now be setting interest rates far below zero, say, at minus 3-4 per cent. This suggests that even as the economy improves, it could be a long time before policymakers are willing to “lift off” from zero and raise rates into positive territory.

Interest rates are hardly the only likely driver of exchange rates; other factors, such as trade imbalances and risk, also are important. And, of course, central banks are engaged in various quasi-fiscal activities such as quantitative easing. But with interest rates basically in a cryogenic freeze, perhaps the single biggest source of uncertainty is gone. In fact, as Ilzetzki, Reinhart, and I show, core exchange-rate volatility was declining long before the pandemic, especially as one central bank after another skirted the zero bound. COVID-19 has since entrenched these ultra-low interest rates.

But the current stasis will not last forever. Controlling for relative inflation rates, the real value of a broad dollar index has been trending up for almost a decade, and at some point will probably partly revert to the mean (as happened in the early 2000s). The second wave of the virus is currently hitting Europe harder than the US, but this pattern may soon reverse as winter sets in, particularly if America’s post-election interregnum paralyses both health and macroeconomic policy. And although the US still has enormous capacity to provide much-needed disaster relief to hard-hit workers and small businesses, the growing share of US public and corporate debt in global markets suggests longer-term fragilities.

Simply put, there is a fundamental inconsistency over the long run between an ever-rising share of US debt in world markets and an ever-falling share of US output in the global economy. The International Monetary Fund expects the Chinese economy to be 10 per cent larger at the end of 2021 than it was at the end of 2019. A parallel problem eventually led to the breakup of the post-war Bretton Woods system of fixed exchange rates, a decade after the Yale economist Robert Triffin first identified it in the early 1960s.

In the short to medium term, the dollar certainly could rise more, especially if further waves of COVID-19 stress financial markets and trigger a flight to safety. And exchange-rate uncertainty aside, the overwhelming likelihood is that the greenback will still be king in 2030. But it’s worth remembering that economic traumas such as we are now experiencing often prove to be painful turning points.

Kenneth Rogoff, a former chief economist of the International Monetary Fund, is professor of Economics and Public Policy at Harvard University. Copyright: Project Syndicate, 2020. www.project-syndicate.org