The G-7 Communique and the Dollar

Was this the new (reverse) "Plaza Accord"?

From Bloomberg:

Lagarde Says G-7's Dollar Shift on Par With 1985 Pact (Update2)

By Christopher Swann and Kathleen Hays

April 14 (Bloomberg) -- French Finance Minister Christine Lagarde said investors haven't grasped the magnitude of the Group of Seven's shift in stance on exchange rates, likening its significance to the 1985 Plaza Accord.

"It's a strong statement which I am not sure the markets have yet fully understood and appreciated," Lagarde said in an interview on Bloomberg Television in New York.

Figure 1: Log nominal value of US dollar against other major currencies. NBER defined recession dates shaded gray. Source: Federal Reserve Board via FRED II.

Lagarde's remarks indicate she may be frustrated that the dollar failed to rally today after the G-7 warned that recent "sharp fluctuations" in exchange rates risk hurting the global economy. The group of seven major industrial nations issued their statement after the dollar slid 8 percent against the euro and 6 percent versus the yen since they last met in February.

The April 11 statement was "not very different" from the importance of the 1985 Plaza Accord, she said. The Group of Five at the time agreed to "coordinated intervention" to drive down the dollar. The G-5 then included the U.S., U.K., France, Germany and Japan. It later expanded to add Canada and Italy.

The article continues, documenting widespread skepticism among financial market participants. This view is summarized by this quote from today's IDEAGlobal newsletter:

The FX markets digested the latest G7 statement with relative ease on Monday, with EUR/USD eventually retracing all its losses posted soon after the statement was first issued. The wording changed significantly, but there no little [sic] meaning behind the change of syntax. The more things change, the more they stay the same. The environment still remains one of very negative sentiment towards the greenback...Monday's US economic outlook release calender did nothing to change this outlook....This supports the notion US continues to be in a recession, leaving the US vulnerable to further losses.

I think this quote does provide several reasons for skepticism, but also highlights why these pronouncements could matter.

First, reasons for skepticism. Policymakers, especially finance ministers, have limited means to affect exchange rates directly. In the case of the United States, the Treasury can intervene in foreign exchange markets, purchasing foreign currency with dollars, and sterilizing the increase in the dollar money supply by selling Treasuries.

Admittedly, the evidence that sterilized intervention works is actually more mixed than is commonly allowed. For certain, there do not seem to be persistent effects on the level of exchange rates from sterilized intervention for major currencies. This is true even when the intervention is in the amount of hundreds of billions of dollar, as in the Japanese experience during 2003-04 ($315 billion to be exact). But they do seem to exist. [0], [1], [2].

When effects of intervention have been identified, they typically (although not always) seem to be of a short-term nature, affecting the direction of the exchange rate's movement over a few days.

On the other hand, China's ability to manage the exchange rate by accumulating hundreds of billions of dollars of reserves has led to some revision. But of course, this is a case where the intervention is not fully sterilized, and is supported by a panoply of capital controls. Whether such an effect would apply for developed country currencies depends upon (in part) whether a portfolio balance channel exists (i.e., whether bonds denominated in different currencies are perfectly substitutable), even if the intervention is coordinated.[3], [4].

Hence, I think these paragraphs from Owen Humpage's "Government Intervention in the Foreign Exchange Market" (2003) summarize the profession's thinking on the subject, insofar as intervention on developed country currencies is concerned:

Sterilized intervention affords monetary policy makers a means of occasionally pushing an exchange rate in a desired direction. The alternative level then serves as a new starting point for a random walk process compatible with existing fundamentals. The empirical support for this conclusions seems consistent with the idea that monetary authorities periodically possess better information than other market participants and, in these instances, can sometimes can affect market expectations through intervention. This description does not preclude intervention as a signal of future monetary policy, but interpreting intervention as solely or even primarily such a signal is probably wrong. The likelihood that a given intervention will have the desired effect increases if the transaction is large and coordinated with the foreign monetary authority whose currency is involved.

Nevertheless, because sterilized intervention does not affect market fundaments, it does not afford monetary authorities a means of routinely guiding their exchange rates along a path that they determine independent of their monetary policies. While monetary authorities in large developed countries certainly can affect nominal exchange rates through non-sterilized foreign exchange intervention, doing so either will conflict with their domestic policy objectives or it will be entirely redundant to open market operation in domestic securities. The outcome depends on the nature of the underlying economic shock to their exchange market.

This highlights the one point where I think G7 pronouncements can matter. If policy makers view the exchange rate as a variable of primary interest, then they will try to alter the fundamentals (tax revenues and government spending, when the finance ministers make the pronouncements). Even if these fundamentals don't change at the time of announcements, if the commitment to change the expected path in the fundamentals is credible, then the exchange rate should change at the time of the announcement.

However, no such commitment seemed to have been made, at least on the fiscal side. What about the monetary side? To the extent that the central bank governors (including Bernanke) were also there, then there could be some informational content in the communique.

Yet, this would require more "weight" on the exchange rate (separate from its influence on output) than has previously been evident in the Fed and ECB reaction functions (estimated weights are fairly small, e.g., [5], and it is hard to determine whether that is the direct effect, or the exchange rate gap is standing in for an effect working through aggregate demand; see the framework in Chinn and Meredith (2004). That's possible. Likely? Well, these are extraordinary times.

Bottom Line: If the Fed perceives that the dollar has dropped far enough to keep the U.S. economy out of a deep recession, and the ECB perceives the euro has risen enough to adversely impact euro area economic activity at a time of a pronounced slowdown (see here), then "the stars will be aligned" for a change in the path of (monetary) fundamentals, and hence the value of the dollar. Until then, the dollar will be buffeted by news about output, incomes, and credit markets (a different portfolio balance channel [6]).

Oh, and by the way, the euro may supplant the dollar as the world's key reserve currency by 2015 if we maintain the policies of the past 7 years. [7] [pdf], Jeff Frankel's blog.

Comments

[Coelacanth]

It may be left over hubris from earilier this decade, on the part of traders, to not take as seriously as they should the language of the the G-7 over currencies. Maybe not imminently but sooner than people might expect, a more concerted effort to influence currencies might happen.

Ultimately I don't think the G-7 has much power. Jawboning can help a little but ultimately the market just needs to work this out. A committment to fundamentals seems like all the current talk about regulation; a good thing which will prove beneficial in the long run but doesn't change the immediate carnage.

We may end up nationalizing Fannie & Freddie and the Fed may be offering FHA loans to people with lousy credit scores before it's all done, but we'll muddle through. LOL.

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