The Battle Ahead: What Role For The U.S. Dollar?

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by: John M. Mason

Summary

Fed Chair Janet Yellen reiterated before Congress yesterday that the Federal Reserve will most likely raise its policy rate three times this year.

The immediate result of this testimony was a rise in yields in the US Treasury market and an increase in the value of the US dollar.

This is not what the Trump Administration wants and is counter to its efforts to build up the manufacturing capability of the United States, something that will cause policy conflicts.

The value of the United States dollar may turn out to be the fulcrum upon which the whole Trump economic policy and the future of the global monetary system turns.

As I wrote earlier in January, the battle for the place of the US dollar was started by Fed Chair Janet Yellen as Ms. Yellen moved early to confirm the Fed's independence to set monetary policy.

Yesterday, in Congressional testimony, that independence was reconfirmed as Ms. Yellen stood by earlier Fed "forward guidance" that the Fed was still intent upon raising it target range of interest rates three times this year and gave hints that the first move would come as early as March. She indicated that changes should not be postponed for too long a time.

There was an immediate reaction in the bond market as the yield on the 10-year US Treasury note rose and touched 2.50 percent yesterday. The note was trading around 2.52 percent Wednesday morning.

There was a reaction in the foreign exchange markets as the value of the dollar also improved with the US dollar index rising above 101.00 at the end of Tuesday. On Wednesday morning the index was approaching 101.50.

Relative to the euro, last week it was taking about $1.0700 to purchase one euro. On Wednesday morning, one Euro could be acquired for $1.0525.

Expectations of future Federal Reserve moves on interest rates only point to continued strength of the value of the US dollar.

But, this gets us into the bigger picture.

The February 11, 2017 issue of the Economist had a very important discussion of the role of the US dollar in the world. The discussion centered on the role that the US dollar has achieved in the world over the past sixty years and the problems that might evolve if the dollar ceases to be the world's major reserve currency.

In essence, the world basically thrives on a US dollar presence. Although there are other reserve currencies and an effort by the Chinese to bring their currency, the renminbi, into greater prominence as a world currency, at present there is really no other alternative to the eminence of the US dollar if the world is to work as well as it does today.

Yet, President Trump and some of his advisors have a more mercantilist view of the world. This world is focused more upon the manufacturing position of a country as opposed to the provision of services.

Martin Sandbu treats this mindset in an opinion-piece in the Financial Times. Mr. Sandbu talks about the backward looking emphasis upon a nation's manufacturing as the backbone of a country's economic strength. He emphasizes first that not everyone can totally focus on manufacturing predominance and then adds to this point that even those countries that have this manufacturing predominance face an uncertain future with a continuing decline in the numbers of jobs that will be available in this sector of an economy.

Furthermore, predominant manufacturing countries, like especially Germany, but also Japan and China, live off of a surplus trade balance. The only way they can maintain their supremacy is to do whatever they can to keep a sufficient surplus account in their foreign trade.

But, this makes it harder for these countries to serve as a reserve currency, because the trade surplus must be maintained.

This is where the United States, as described in the article in the Economist, has excelled. The United States has learned to live with its position as a country with a deficit in its trade balance and to live with its position as the support of the world financial system with the dollar as the principal reserve currency. The United States, in this role, has basically underwritten the post-World War II opening up of the world, globalization, and the fantastic expansion of global wealth.

The world is dependent upon the dollar, wants a strong dollar, and, as is argued in the Economist article, grows nervous when the idea of a strong dollar is threatened.

However, the alternatives that come with fighting against a strong dollar and with greater protectionism and a mercantilist approach to building up the manufacturing position of the United States has its downsides.

Thus, the setting for the looming battle.

It has already been noted that the battle will accelerate in February. Ms. Yellen's testimony is just one event in the month that will attract the attention of the press.

But, this conflict will not go away. And, as a natural part of Trump-world, the battle will become more contentious as we go along.

In terms of the Federal Reserve, it must be remembered that President Trump has three positions on the Fed's Board of Governors that need to be filled. Furthermore, with Republican control of Congress there is concern that other structural changes might be made to the Fed and Federal Reserve governance.

Dollar politics is going to be a major issue over the next four years. As mentioned at the start of this article, the dollar issue may become the fulcrum upon which a lot in the United States and the world turn upon. It is important to remember that the US dollar plays such a crucial role in the world that any changes that impact the value of the dollar will have vast repercussions throughout the globe.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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