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What were historic drivers for dollar valuation?
Various macro events and monetary policy changes in the past had helped to both increase and decrease foreign reserve demands for the dollar.
- Under the the , dollar was convertible to gold (initially at the rate of $35 per ounce) from 1944 to 1971. During the 40s and 50s, decimated post-war economies in Europe and Asia had to rely on the dollar, and international reserve demand helped fueled the U.S. post war growth
- Foreign demand was so strong during that time that Federal Reserve’s (under directive from the Treasury Department) from 1942 to 1951 was readily absorbed by other countries
- Following the
The Eisenhower administration supported [Chairman] Martin’s objective of price stability. In 1957, in response to an increase in inflation to 3%, the Fed tightened monetary policy and the economy entered into a sharp recession in August 1957. In 1960, in response to gold outflows, the Fed again pursued a restrictive monetary policy, and the economy entered into recession in early 1960. As a result, in the early 1960s, the assumption of price stability conditioned expectations in financial markets.
, the Federal Reserve regained its policy independence and proceeded to tighten monetary policy in 1957, and dollar again strengthened
- Subsequent loose monetary policies throughout the 60s (please see below) increased money supply, and Germany and Japan’s emergence out of the shadows of WWII had also pared their reliance on the dollar. Thus, even though dollar was still the world’s reserve currency, depreciation pressure made it increasingly difficult for the U.S. to maintain dollar’s gold peg, leading to the
In the Johnson administration, the Council of Economic Advisers clashed with Martin over the timing of increases in the Fed’s interest rate instrument. James Tobin, a member of the Council, summarized the difference as one of “levels” versus “first-differences.” That is, the Council wanted the Fed to refrain from raising rates until the unemployment rate approached its presumed full-employment level of 4%. Martin believed that the Fed should raise rates early in an economic recovery when the economy began to grow vigorously.
Appointments to the Board of Governors by Kennedy and Johnson also meant that Martin had to deal with an increasingly Keynesian Board of Governors and the prospect of a divided house if he challenged the political consensus. According to Keynesian models, there was a trade-off between policy instruments: monetary policy could be accommodative if fiscal policy was tight. In summer 1966, the FOMC did raise interest rates but it did so in the context of what was then a large deficit apart from wartime. Starting in 1967, Martin worked with Treasury Secretary Henry Fowler in an attempt to get a tax increase that would bring the government deficit into surplus and, presumably, remove the pressure on interest rates.
However, achieving agreement between President Johnson and Wilbur Mills, chairman of the House Ways and Means Committee, who wanted cuts in Johnson’s Great Society programs, proved to be a long process. Not until June 1968 did Congress pass an income tax surcharge, which briefly turned the federal government deficit into a surplus. However, despite the tax increase, money growth remained high and inflation rose. By 1969, Martin realized he had made a mistake and pursued a restrictive monetary policy to bring inflation and inflationary expectations under control. In 1969 in the Board library, he told the other governors that he had failed. With the end of his term in January 1970, he ran out of time to restore price stability.
and end of Bretton Woods.Inflation’s upward trajectory between mid 1960s to early 1970s
In conclusion, it is not easy to disentangle dollar valuation from its reserve status, because the dollar had been a reserve currency since 1944. Its valuation is thus a function of changing money supply (as highlighted in the question) and changing demand (both domestic and international). It is worth mentioning that all dollar valuation and money stock charts frombegin after the end of Bretton Woods, making historic comparison pre-Bretton Woods difficult to assess.
Trade weighted dollar vs. money stock and FED short-term rates. In fact, dollar valuation had been fairly steady (over the long-term) against major trading currencies
Next article12 01 2015 | by Victor Xing | Capital Markets