Morgan Stanley On The Fed’s Quantitative Easing And The US Dollar

From a client folio prepared by Morgan Stanley. Very illuminating analysis on the USD trends:

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Currencies
The Fed’s QE Operations and the Dollar
November 28, 2008

Summary and Conclusions

The Fed has commenced QE (quantitative easing). In this note, we review the concept of QE and analyse the likely impact of this extraordinary operation on the dollar. The upshot is that, since monetary policy, including QE, is a ‘nominal’ operation, the operation itself should not have significant implications for the real value of the dollar. The nominal dollar value should, thus, only be affected if QE alters the outlook of inflation in the US over the medium term. Also, whether QE by the Fed should erode the value of the dollar should be assessed relative to what other central banks do. To the extent that the ECB and the BoE also conduct QE – which is the case – the impact of QE on the dollar is not necessarily negative.

Having said this, though QE per se should affect the dollar through relative inflation as well as inflation expectations, the underlying structural problems that forced the Fed to conduct QE in the first place should alter the fundamental value of the dollar, relative to those of other currencies. The parlous state of the US financial system should, in theory, be reflected in a lower value of the dollar, had it not been for its hegemonic reserve currency status propping the dollar up during this deleveraging phase. The bloated fiscal deficits (which we assume will exceed those of the G7 countries) will further weigh on the intrinsic value of the dollar.

In sum, whether QE by the Fed is negative for the dollar depends on the inflation outlook of the US and the resulting inflation expectations. But at a fundamental level, the dollar’s intrinsic value has indeed deteriorated with its severely weakened financial sector. We maintain our core view that the dollar should continue to appreciate as the world slows – which we assume will last until next summer – but could give back some of the gains when deleveraging stops and the recovery phase for the US economy proves to be more protracted and treacherous than for other economies. The size and vigour of the dollar rally against the majors in the next six months or so are also likely to be more tempered than we have had in mind, in light of the deteriorating fundamentals in the US. Our call on EM currencies remains unchanged.

Background Discussion on QE

As inflation falls, and the unemployment rate rises, the Fed is likely to embark on QE to sustain monetary stimulus even when the FFR approaches zero. Broadly speaking, central banks can ease by either altering the price of money (i.e., interest rates) or the quantity of money. While policy orthodoxy these days is focused on the former lever, when short-term nominal interest rates approach zero as inflation falls, central banks could in principle use quantitative channels through which to impart monetary stimulus. Since it is the real interest rate that affects economic activities, the zero bound on nominal interest rates exposes an economy with deflation to persistently positive real interest rates. This was the situation faced by Japan in 2000, that interest rates were cut to zero but there was still not enough demand for money for monetary policy to work. That was an old-fashioned case of a ‘liquidity trap’.

However, for the US, Europe and the UK, the current situation is somewhat different. Interest rates are still above zero. The problem monetary authorities face is not quite deflation and inadequate demand for money (i.e., a deficient aggregate demand problem) – though this problem could emerge if demand slows further. Rather, monetary policies lack traction mainly because there is no longer a smooth transmission mechanism from the short-term policy interest rates to broader monetary aggregates, credit and aggregate demand. As a result, Japan had QE with ZIRP, but in the US, Euroland and the UK, there is QE without ZIRP.

There are essentially three broad channels through which a central bank can conduct unconventional monetary easing. First, a central bank could ‘do things’ (i.e., through communications or QE) to foster the expectation that short-term interest rates will stay low for an extended period of time. Indeed, this was the primary aim of the BoJ during its QE episode between March 2001 and March 2006. The FOMC statement in August 2003 which stated for the first time that “policy accommodation can be maintained for a considerable period” is another example of this type of commitment to monetary easing. Second, a central bank could increase the size of its balance sheet to foster an expectation on the future path of inflation. (Currently, the Fed’s balance sheet is around US$2 trillion, up from US$900 billion in August.) The intuition of this ‘money printing’ method of QE is obvious. Third, a central bank could alter the composition of its balance sheet. Assuming that investors treat different assets as not perfect substitutes, central banks’ purchase operations of selected assets could materially alter their prices. The best example is long-term US Treasuries. In theory, the Fed could purchase large amounts of Treasuries to cap the yields, just as the BoJ did through its rinban operations during the QE period. These three different methods of QE are conceptually distinct but operationally fungible. As the US economy slows further, we expect that the Fed will put all three methods of unconventional easing into practice.

The Fed began expanding its balance sheet in September. It may be useful to consider two motivations for QE by the Fed. The first is to take on market securities in an attempt to ‘jump-start’ the banking system; the second is to take on some of the intermediation duties that the private sector has refused to conduct. We looked at how the expansion in the Fed’s balance sheet compares with the experience of the BoJ during the QE period that spanned from March 2001 to March 2006, during which time the BoJ’s balance sheet expanded from around 13% of GDP to about 22% (we measure the balance sheet by the monetary base for both countries). Due to fundamental differences in the financial systems of the two countries, the Fed’s balance sheet has historically been substantially smaller than that of the BoJ – it averaged around 6% of GDP prior to this crisis. By October, however, the Fed’s balance sheet had been expanded to more than 8% of GDP – a 35% increase.

To properly assess the impact of ‘money printing’ by the Fed on inflation, it is important to track the evolution of broader monetary aggregates, and observe how the ‘money multiplier’ – the ratio between broad money and the Fed’s balance sheet – changes over time. We looked at the trajectories for M2 of Japan and the US. During Japan’s QE period, its M2 expanded from around 125% of GDP to more than 140%. In the US, M2 has expanded from 53% to 57% of GDP since September. While the latter is a sharp surge, M2/GDP is not substantially higher than it was during 2003, when the Fed drove the FFR towards 1.00%. Indeed, most of the surge in the figure comes from the anticipated sharp drop in 4Q nominal GDP. To summarise, while base money has increased dramatically (by 34% since August), M2 has grown by only 2.7%.

The reason for this, of course, is that the ‘money multiplier’ (MM) has collapsed, reflecting a severe breakdown in the ability and the willingness of the bank and non-bank entities in the US to intermediate capital to the extent they had done prior to the crisis. The collapse in the US MM is significantly more severe than in the case of Japan, during which time Japan’s MM fell from around 10 times the size of the BoJ’s balance sheet to around 6.5 times (a fall of 35%). In the US in the last two months, we have seen the US MM falling from more than 9 to around 7 (down 22%).

Will QE by the Fed Weaken the Dollar?

Our short answer is ‘no’. But whether this answer is right depends on a number of assumptions. (1) Deflationary pressures cannot be dismissed so easily in this cycle. Analysts can have their views on the inflation/deflation debate; however, to us, the fact that, with half a dozen ‘nuclear options’, the world’s policymakers have not yet succeeded at halting or containing the crisis worries us. It is, to us, very difficult to argue convincingly that ‘it’ won’t happen in the US or elsewhere in the world (see Vice Chairman Don Kohn’s speech last week). While the probability of this risk of sustained deflation is not high, it may be too high for comfort. Though the Fed did act much sooner than the BoJ, the underlying problem is arguably more serious and the financial crisis has severely shocked the ‘money multiplier’, forcing the Fed to intermediate on behalf of the private sector. In short, we fear deflation now more than we fear inflation tomorrow, because we simply have no confidence that this will merely be a ‘deflation scare’.

Our guess is that the Fed and other developed country central banks have a similar asymmetry in fear of the two tail risks: this risk-management approach to monetary easing indeed reflects the asymmetry. (EM central banks have lingering concerns about inflation.) In a way, investors realise this and are betting on the G7 central bankers to overwhelm and neutralise the left tail risk, leaving the risk of the G7 ‘overdoing’ (i.e., over-easing) it more prominent than the G7 failing to re-ignite their economies. In other words, the greater the fears of deflation, the more will be done by central banks to avoid that scenario and, as a result, the higher the risk of inflation in the out-years, or so it is thought. (Ironically, it was this stance the Fed had in 2001-03 that arguably sowed the seed for the ensuing credit bubble.) Having said this, this thought process is logical but very subjective, with no clear right answer, in our view. But tactically, we believe it is wise to bet that the deflation scare will be more powerful a market force as the global economy falters and as central banks fight the ‘icing problem’. Whether there will be inflation is a debate for another day, probably three months from now, and it will probably not be reflected in market pricing, we suspect.

Whether the dollar depreciates depends on whether investors believe that there will be runaway inflation in the US over the medium term. Our view is that the Fed will most likely have time to retract on QE in time to keep a lid on inflation. Without inflation, the dollar cannot be weakened by nominal operations, ceteris paribus. Our guess is that, while dealing with a liquidity trap is difficult, removing stimulus when macro conditions normalise should not be a major problem for the Fed. But this discussion also highlights the importance of the Fed having a credible ‘exit strategy’ for its QE operations. This is essentially the view of Minneapolis Fed President Gary Stern.

Further, while many are focused on this question of QE by the Fed and the dollar, we argue that the ECB will likely be forced down the same path soon. The European and the UK banking systems are just as unwilling to intermediate capital as the American banking system. The ECB and the BoE, therefore, will likely be forced to do some of the intermediation on behalf of the private sector, just as the Fed has been forced to do. So if the Fed, the ECB and the BoE adopt QE, what is the net result on EUR/USD or cable? We think it is very unclear that EUR or GBP will necessarily rally, as is presumed by some investors when they think about the Fed.

Ironically, the tug of war between deflation and inflation fears indicates a reverse Dollar Smile mechanism of sorts. Recall that our Dollar Smile framework suggests that the dollar rallies when the US economy is stronger or weaker than the rest of the world. In the intermediate state, which we call the gutter, the dollar is weak. In the deflation versus inflation debate, on the other hand, both these extremes imply a weak dollar, while the intermediate state would foster dollar strength.

The USD’s Fundamental Value Undermined?

While the Fed’s QE operations affect the nominal value of the dollar through inflation, the severe deterioration in the US financial system must have had an impact on the intrinsic value of the dollar. We stress again that exchange rates are a relative concept, so we need to be sensitive to how much structural damage the financial systems of other developed countries may have sustained. This also includes the fiscal burden that these countries have to take on because of this damage. Notwithstanding all the problems in the US banking system, the size of banks’ balance sheet is much smaller in the US than in many other countries. For example, total bank liabilities are around 650% of GDP for Switzerland, 430% for the UK, 320% for the Euroland, 150% for Japan and 85% for the US. Investors should keep this fact in mind.

In any case, as a rough guesstimate of how the USD major index may be affected by the breakages in the US financial system and the remedial policy actions, we simulated, using our multilateral USD index fair value framework, how the major USD index might be affected by prospective changes in relative productivity, relative terms of trade, relative fiscal positions and the US NFA (net foreign asset) position. Our simulations are centred on the last two variables, as we believe that it is difficult to draw a clear link between the banking sector and relative productivity and the terms of trade.

It looks likely, based on recent developments, that the relative US fiscal position may deteriorate by 2% of GDP, and its NFA position may also deteriorate by 3% of GDP (the US C/A deficit is expected to shrink but will still be large). This scenario maps to a 5.3% depreciation in the fair value of the major USD index, according to our valuation model (the impact of NFA is small due to the small magnitude of the estimated coefficient in our model).

Bottom Line

There are two considerations in thinking about the impact of the Fed’s QE operations on the dollar. First, QE per se can only affect the nominal value of the USD through relative inflation. The greater the inflationary pressures generated by QE, the more the dollar could weaken. Second, the underlying reasons why the Fed has been forced to undertake QE operations may undermine the intrinsic value of the dollar by 5-7%. Thus, while we still expect the dollar to appreciate as the global economy falters, the size of the USD rally against the majors in the next six months will likely be more modest than we had thought. Against the EM currencies, we continue to expect significant USD strength in the next six months.