Are central banks really driven by the U.S. dollar?

Embed from Getty Images

Lately there have been suggestions that central banks’ actions are driven by a hidden agenda of keeping the U.S. dollar strong or weak.  It is not really a surprise to hear this as, for instance, the U.S. Federal Reserve announced that it sees only two rate hikes in 2016, which is half the number it said last December 2015; thus most observers deduced that the Fed has a hidden agenda of trying to keep the U.S. dollar down.  Others even went one further by saying that the reason why central banks in Japan, Europe and China are pushing their own rates down is that there is supposedly a so-called secret Shanghai Accord (at the recent G20 meeting of finance chiefs) of trying to push up the value of the U.S. dollar.  So, the question here is, are central banks really that concerned with the value of the U.S. dollar?

Embed from Getty Images

Here are several factors to consider.

U.S. Federal Reserve.  Keeping U.S. interest rate down will make the U.S. a less attractive destination for short-term capital to be parked as it gives inferior return to investment, which means that short-term capital will leave the country and in theory none will come into the country.  The simultaneous greater outflow and smaller inflow of short-term capital translates into a net outflow of capital, and this means that there is simultaneous greater supply and smaller demand of the U.S. dollar that translates into a net supply of the dollar.  This will automatically push down the value of the dollar.  But here is the fallacy of the pro-exchange rate argument – when the value of the dollar is low, it will make U.S. exports cheaper and imports into the U.S. more expensive; this in time will drive demand for U.S. exports to the outside world greater than demand for imports into the U.S. market, which translates into a simultaneous greater export volume and smaller import volume, or net export.  As export boost the demand for U.S. dollar by foreign buyers who need more dollars to pay for U.S. goods and services, and import requires more U.S. dollar to be exchanged into foreign currencies to pay for imported goods and services, thus a net export scenario means a net demand for the U.S. dollar.  This will automatically push back up the value of the dollar.  All other things remain constant, the cyclical trade activities of the U.S. against its trading partners automatically regulates the exchange rate value of the U.S. dollar, with or without the Fed intervention, as the trade cycle is continuous.  Knowing this, it is therefore a fallacy to suggest that the Fed has the value of the dollar in mind when it decides to keep U.S. interest rate up or down.  In fact, Fed chair Janet Yellen herself said that, “Movements in exchange rates… are a factor…”  What she meant is that yes, the value of the U.S. dollar is a factor, and no, it is not the only or indeed a significant factor at all.

Other central banks.  Keeping their national interest rates down will bring down borrowing costs, thus make their economies more attractive to local and foreign investors and enable more ordinary people to become eligible for housing and motor vehicle loans.  This will boost the rates of investment, consumption and trade in their economies.  Their gross domestic production will grow, unemployment rates will fall, and inflation rates will start to rise once more.  In fact, this is precisely what the European Central Bank, Bank of Japan, and People’s Bank of China have been trying to do.  Their actions have nothing to do with a so-called Shanghai Accord or any secret conspiracy to influence the value of the U.S. dollar.

Comments welcomed.