The Mighty Dollar

With tax cuts and tax returns on everyone’s minds, we think it is a good time to look closely at our favorite currency!  We might call it “dough”, “bread” or “cheddar”, we have “bean”-counters to keep track of it and we use simple, gastronomic valuations, like the Big Mac Index, to compare it to its peers.  Thinking about the US dollar and its’ value might just make you hungry!   The dollars’ worth is determined by the foreign exchange market, but investors and economists alike are always looking for ways to value the currencies and look for explanations or even monetary conspiracies, to explain currency fluctuations.

In 1986, The Economist came out with the Big Mac Index as a simple way to discuss exchange rates and purchasing-power parity (PPP), which compares the amount of currency needed to buy the same item in different countries, in this case a Big Mac. The Wall Street Journal came up with their own modernized version of this same idea with their Latte Index, which compares the price of a Starbucks tall latte in cities around the world.  For example, in New York City, the WSJ reporter could buy a tall latte at Starbucks for $3.45.  Other WSJ reporters would need to spend $5.76 in Zurich, $4.22 in Shanghai, $3.40 in Berlin (almost the same as the U.S.), $2.84 in London and $1.53 in Cairo.  These simple comparisons of the price of a good that is available in many countries can be an indicator of whether foreign currencies are over-valued or under-valued relative to the US dollar.

There are some criticisms of these simple tools.  Costs of these products can depend on local wages or rents, which are generally more expensive in richer countries and can add to the cost of the product.  The price for a Starbucks Latte can even fluctuate amongst American cities or specific locations, like airports, which may have higher rents.  And adjusting these indices for GDP will change the data and perhaps improve their accuracy.  Some also have pointed to the ingredients in these particular items as causing value differences.  McDonald’s, for example, must use strictly British beef in the U.K.  Starbucks can be a little more consistent, as coffee beans are not generally grown in most of the countries they operate in, so the imported price is pretty standard.

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What these indices don’t tell us about the currency market is why fluctuations occur.  For example, why has the U.S. dollar hit a recent three-year low?  According to an article in yesterday’s WSJ, one simple explanation for a weakened dollar is that “the economies in the rest of the world are finally growing again, so their currencies are strengthening. The U.S. economy isn’t improving as fast—because it was stronger to start with—so the dollar’s falling.”  The Chinese yuan has gained 3.8% so far in January after gaining 6.7% in 2017, which has the officials at the People’s Bank of China concerned about their exports.  President Trump and the U.S. have been critical of any Chinese central bank policies that would devalue the Chinese currency and cheapen goods coming into the U.S.  This trade friction complicates China’s management of their currency, particularly as they attempt to make the yuan a more market-driven currency.

Adding to the currency gap with China and the drop in US currency values overall were comments made last week by the U.S. Treasury Secretary signaling Administration support for a weaker U.S. dollar as being “good for trade.”   Such overt comments are traditionally avoided by the Treasury Department, but may spotlight the Administration goals to reduce the trade deficit and allow currencies to float freely.  President Trump reiterated his stance on trade imbalances in his State of the Union address, pledging to “fix bad trade deals” and that he expects trade deals to be “fair” and “reciprocal”.  Another factor that may weaken the dollar is the belief that 2018 will bring a tightening of monetary policy by the international banks.  Some banks, like the Bank of Canada and Bank of England, have already raised rates.

A weaker dollar makes U.S. goods cheaper to foreign markets, but there is a risk of undermining confidence in an array of U.S. assets, like the U.S. Treasury market.  As the WSJ article explained, as the new tax law expands the federal budget deficit, the government will look to sell the debt to foreign investors.  Those investors may demand higher rates to compensate for the risks of a weaker currency and those costs could fall onto the U.S. taxpayers.

So, we should think about our American dollar today and perhaps look at our paychecks or tax returns to see what has changed.  At DWM, we are always careful to think about each and every one of your dollars – the ones you invest, the ones you save, the ones you spend and the ones you pay in tax.  Using the simple Big Mac or Starbucks Latte indices might help us remember all the factors that go into the value of a dollar around the world.  For me, I certainly prefer to imagine buying a tall latte in Zurich over a Big Mac!

 

 

Ben Bernanke’s Latest Report to Congress

Ben Bernanke reportOn February 29th, Federal Reserve Chairman Ben Bernanke gave his biannual “Humphrey-Hawkins” report on monetary policy to Congress. In short, Mr. Bernanke testified that the “recovery of the U.S. economy continues, but the pace of expansion has been uneven and modest by historical standards.”

Mr. Bernanke noted recent “positive developments in the labor market” but said that the job market remains “far from normal.” He indicated very little worry about inflation even with the recent rise in energy prices. He pointed to advanced household spending in 2011, even though “the fundamentals that support spending continue to be weak: real household income and wealth were flat in 2011 and access to credit remained restricted for many potential borrowers.”

In the housing sector, he testified that affordability has increased, however many potential buyers lack the down payment and credit history to qualify for loans and others are reluctant to buy due to their concerns about “their income, employment prospects and the future path of home prices.” Mr. Bernanke outlined increases in manufacturing production and capital expenditures, yet indicated that the consensus of the Federal Open Market Committee is that GDP will increase overall by only 2.5% in 2012. 

Mr. Bernanke indicated that the target range for the federal funds rate remains at 0-1/4% and is expected to stay near that until the end of 2014. If so, mortgage rates should stay low and C.D. rates will be just slightly above zero for the next three years. He left the door open to a new program of mortgage-bond purchases to drive long-term rates even lower.

The Fed Chairman testified that a number of “constructive policy actions have been taken of late in Europe”. He continued, “We are in frequent contact with our counterparts in Europe and will continue to follow the situation closely.” One day after Mr. Bernanke’s testimony, the Euro-zone finance ministers said they were ready to give Greece the money it needs provided a bond swap that will cut the debt Greece owes it private creditors goes according to plan this week. At the same time, European economic data released on March 1st was grim. Overall unemployment hit a 15 year high, while inflation unexpectedly accelerated.

Zanny Minton Beddoes, of the Economist speaking on NPR’s Morning Edition last week, put the potential impact of the European problems on the America recovery this way: “In the past few months, the Europeans have successfully covered their festering sore with a massive, great Band-Aid. And, now the acute crisis has turned into a chronic one. With that, we can take off the table the risk of a financial catastrophe in Europe.” Let’s hope so. We’d like to keep the momentum going on our current U.S. recovery.

For more information: http://www.telegraph.co.uk/finance/economics/9113704/Ben-Bernankes-monetary-policy-report-to-Congress.html