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No stranger to empty threats, President Donald Trump designated China as a “currency manipulator” earlier this month and has complained about the strong US dollar despite having few tools to deal with it even if action were justified, which is not the case.
Nevertheless, if the administration must act, the Treasury could sell dollars to try to drive down the dollar. But the Federal Reserve, which traditionally has coordinated with Treasury on foreign exchange purchases, is not likely to join in the selling. The Fed could, however, bolster Treasury’s capacity to act alone. But dumping dollars would signal that the United States itself was manipulating its currency, further weakening America’s reputation around the world.
Simply put, the facts do not support US intervention under current circumstances. The Federal Reserve should try to convince the Treasury that intervention would be a dangerous policy mistake. If, despite the Fed’s advice, the administration proceeded, the Fed should not join the action.
The administration could go it alone up to a point. It could use the Treasury’s own Exchange Stabilization Fund (ESF) to purchase a limited amount of foreign currencies. The Fed could support such an action indirectly. Declining to do so would risk a major confrontation with the administration.
The Dollar Has Not Strengthened Significantly
Currency levels do affect trade flows. A higher value for the dollar makes US exports more expensive and its imports cheaper, potentially affecting the trade balance. The same is true for China and its currency, the renminbi.
The slight weakening of the Chinese yuan in response to the prospective US imposition of increased tariffs on imports from China, a phenomenon that the administration labeled manipulation, was in fact a natural economic reaction. China has not manipulated its currency since 2010, when its current account deficit was already declining.
Moreover, the dollar has not strengthened significantly since Trump was elected. Through August 9, the buck has appreciated on average against all currencies about 5 percent based on the Federal Reserve’s indexes. Adjusting for the lower US rate of inflation, the average appreciation in July was been less than 1.5 percent. The International Monetary Fund estimates that the dollar is overvalued in price-adjusted terms by 6 to 12 percent, approximately the same overvaluation that was estimated in two previous reports. Moreover, with the US economy at close to or above full employment, an exchange-rate adjustment of this magnitude, if it could be achieved, would not boost GDP. Rather, it would reallocate output toward export and import-competing goods and services and away from consumption and investment.
The United States Would Have to Act Alone, Reducing Its Effectiveness
Since the advent of floating exchange rates in 1973, essentially all US operations have been coordinated with partner countries. The United States last conducted large-scale intervention operations in 1995. Because the facts do not support intervention to depress the dollar at this time, the United States would have to act alone. This would undercut any chance of sustained effectiveness of intervention and further isolate the United States. US unilateral intervention would add to economic uncertainty and risk substantial negative spillovers to other financial markets and ultimately to the US and global economy.
The balance sheet of the ESF is about $95 billion, $21 billion of which is holdings of euros and yen. The remaining $84 billion consists of $23 billion in US Treasury securities and $51 billion in special drawing rights (SDR). Sale of this amount is unlikely to have any lasting market impact. Market participants, who may be talking their own books, argue that to depress the dollar, sales of dollars would have to be in the hundreds of billions.
The Role of the Fed
Because the Treasury lacks the dollar fire-power by itself, it would turn to the Fed. Since 1980, the ESF and the Fed, with rare exceptions, have shared sales and purchases of foreign exchange fifty-fifty. Both have legal intervention authority. However, the Treasury may not direct the Fed to do so, and the Fed may operate without Treasury permission—and vice versa. Therefore, the Fed and Treasury cooperate.
Historically, Treasury-Fed cooperation in this area has been based on two principles. First, the Treasury secretary sets US exchange rate policy. Second, the Federal Open Market Committee (FOMC) sets monetary policy independently. In recognition of these principles, the FOMC’s authorization for foreign currency operations instructs the manager of the Open Market Account to conduct Fed foreign exchange operations “[i]n close and continuous cooperation and consultation, as appropriate, with the United States Treasury.”
How should the Fed apply these principles if the Treasury were to propose large-scale US intervention today? First, the Fed should seek to convince the Treasury that doing so would be a major mistake. Second, if the Fed failed, it should not join in selling dollars. Third, to reduce the risk of another confrontation with the administration, the Fed should agree to leverage the ESF’s balance sheet.
Three leveraging mechanisms are available. First, the Fed could offer no objection to the ESF’s monetizing the rest its SDR holdings, accepting SDR certificates in exchange for dollar balances at the Fed which the ESF could sell. (The Fed now holds $5.2 billion in SDR certificates.) Second, the Fed could agree to implement an existing arrangement to buy up to $5 billion of the ESF’s $21 billion in euros and yen, provided the ESF commits later to repurchase the foreign exchange at the same exchange rates, called “warehousing.” Third, the FOMC could vote to expand warehousing without limit.
Thus, the Fed could demonstrate that, despite its strong reservations about intervention at this time, it was consulting and cooperating continuously and closely with the Treasury. In doing so, the Fed would facilitate the Treasury’s exercise of its authority to set US foreign exchange policy while preserving its monetary policy independence.
