The euro is getting stronger, the dollar is getting stronger even faster.
Part 1: Focus on prices, not rates
Many press reports are attributing the fall in oil prices (in dollar terms) to the ongoing depreciation of the euro. I believe this is wrong. If I am not mistaken, the standard argument goes something like this:
1. A falling euro means a rising dollar. (So far so good, if we are talking about the euro/dollar exchange rate then this is a tautology.)
2. A rising dollar will, ceteris paribus, tend to lower commodity prices. (Again, I agree.)
But here’s what people forget. That same argument implies that a falling euro should raise the euro price of oil. But in fact, the euro price of oil is also falling sharply. So what is going on?
The basic problem here is mixing an absolute price (oil) with a relative price of two monies. Let’s take a simple example. Suppose the euro situation had no effect on the average world price of oil, in real terms. Alternatively, think of the trade-weighted price of oil being stable. Now suppose that the euro and countries loosely linked to the euro are 1/2 the world economy, and the dollar and countries loosely linked to the dollar are the other half. If the euro bloc currencies fall 10% against the dollar bloc, what should happen to nominal oil prices? The initial assumption was stability in the real price of oil. If the world oil price is to be stable, the dollar price must fall 5% and the euro price must rise 5% to reflect the 10% depreciation of the euro bloc currencies. But this is not at all what is actually happening. Oil prices are falling fast in dollar terms, but they are also falling fast in euro terms.
The basic problem here is that exchange rates tell us nothing about absolute values. Two neighboring countries each experiencing 100% hyperinflation might very well have currencies that are stable vis-a-vis each other. But the two currencies would be highly unstable against the prices of all other goods and real assets. So how do we figure out what is really going on?
My suggestion is to try to figure out which currency is unstable in an absolute sense. Yes, a fall in the euro relative to the dollar means (by definition) a rise in the dollar relative to the euro. But in which country has there been a de facto switch in monetary policy? Is money getting easier in Europe? Or tighter in America?
Interest rates are lower in America than Europe, but I think you know by now that interest rates are an even more meaningless indicator of monetary policy that exchange rates. Low rates are just as likely (maybe more likely) to reflect a weak economy suffering from too little money, as they are to reflect an easy monetary policy. Instead of looking at rates, I find an absolute standard in prices. And the most sensitive prices are real asset prices; commodities, stocks and real estate.
We don’t have good real time real estate price indices, but we do have good data for stocks and commodities. Obviously stock prices are falling in both dollar and euro terms. But even oil is falling in both dollar and euro terms. I couldn’t find a graph of oil in euro terms, but this graph shows oil is down 20% in the last month or so, and the euro’s down about 10% from its 1.36 level of April. Based on this data alone, you’d say monetary policy is too tight in both the US and Europe, but especially too tight in America. Thus rather than saying the euro is falling, I’d prefer to say the dollar is appreciating. The euro might actually also be appreciating in an absolute sense, just more slowly than the dollar.
Now of course the asset prices don’t tell the whole story. The most important indicators are not available in real time. These included prices, output, and of course my favorite, NGDP growth expectations. But in the next section I will argue that these broader indicators also suggest money is too tight in both Europe and the US.
Part 2: Dude, where’s my hyperinflation?
I have run this blog for 15 months, and my right-wing readers (which are 90% of my readers), keep telling me I don’t know what’s going on in the real world. People fear high inflation. Double-digit inflation is just around the corner. And for 15 months I have been telling my fellow right-wingers that the real problem is excessively low inflation (or more precisely low NGDP.) How am I doing so far? This is the latest data on core inflation:
WASHINGTON “” Consumer prices declined in April for the first time in 13 months while core inflation rose over the past year at the slowest pace in 44 years.
The Labor Department said Wednesday that consumer prices edged down 0.1 percent last month, reflecting a big fall in energy prices. Core inflation, which excludes volatile food and energy, was flat in April. Over the past 12 months, core inflation is up just 0.9 percent, the smallest increase since 1966.
If you take the mainstream “Taylor Rule” approach to monetary policy, the Fed should aim for about 2% inflation, but also be flexible when there are real shocks. Thus if output is below the norm then a bit more inflation is acceptable, and if output is above the norm than the Fed should aim for less than 2% inflation. Output is clearly below normal right now, and hence inflation should be well above 2%. Instead, core inflation is 0.9% and trending downward. And these figures don’t yet include the effects of dollar appreciation.
In Europe the broader aggregates also suggest that easier money would be desirable, even if one ignores the debt problems in the Mediterranean countries.
So the bottom line is that whether you look at market sensitive indicators like commodities, stocks, TIPS spreads, etc, or broader aggregates, money is too tight in Europe. In America it is also too tight; indeed market sensitive indicators suggest that the problem has been getting even worse over the last month. In absolute terms the euro is strong, and the dollar is even stronger.
This is very counter-intuitive, as the shock causing these changes (Greece) would seem to weaken the euro. But that doesn’t seem to be happening–if it did then you might expect real nominal asset prices in euro terms to be rising. Instead the crisis is leading to an increase in the demand for what Nick Rowe calls “the world’s most moneyish money.” It’s a strong dollar crisis that has been misdiagnosed as a weak euro crisis. If this sounds familiar, recall in July – November 2008 the dollar also rose sharply against the euro, and once again 99% of pundits failed to recognize that the excessively strong dollar (reflected in falling asset prices and falling NGDP growth expectations) was the real problem, and the worsening of the banking crisis was a symptom.
PS. Just to be clear, the original 2007 to early 2008 subprime crisis was not caused by a strong dollar—the pundits were correct about the first half of the crisis reflecting banking/regulatory mistakes. It’s late 2008 where the misdiagnosis occurred.
PPS. Yes, I know that exchange rates are actually prices, but there are called “rates,” hence the title of part one–which lumps them in with interest rates.
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19. May 2010 at 07:08
Inflation is down http://www.economist.com/blogs/freeexchange/2010/05/inflation
19. May 2010 at 07:14
I know I might be alone with this, but I would still argue that the jump in oil prices which depressed vacation travel (and hurt areas like Miami, Las Vegas, and Arizona) and caused a big drop in auto sales (hurting the midwest a great deal) was a significant start to the troubles. The Fed reacted by slightly raising interests rates. You had a record number of adjustable rate mortgages resetting at the same time that oil prices were causing troubles in vacation related industries and the auto industry. (Look at all the manufacturing jobs that have been lost in the last few years.)
This would have caused a significant slowdown on its own.
However it also exposed the weaknesses in the financial sector which fell as the next domino.
Lastly, I would argue that the leftward shift in the political polls also increased uncertainty about the future.
IE Oil price spike leads to recession, exposes weakness in financial sector, occurring during a period of pretty radical political change.
Your view on current oil price changes and currency changes is compelling.
I am interested in your views on the ban on naked shorts.
19. May 2010 at 07:44
Half of me always wants to say to the right-wingers, who expect high inflation: “yes, you are right! better dump those dollars now, and buy some real goods and assets!”. If more people were like them we wouldn’t be in this deflationary recession now.
There’s a true paradox here. Bernanke wants (or ought to want) people to fear inflation. Yet he also wants to argue that the risk of inflation is very low, which is why he needs to keep interest rates low. His only way out of the paradox is to make an argument which is very convincing to people inside the Fed, and is seen by outsiders to be very convincing to people inside the Fed, but is at the same time totally unconvincing to people outside the Fed. Not an easy task.
And that paradox comes solely from the fact that monetary policy is framed in terms of a time-path for a nominal interest rate.
Back to the Euro/USD/oil. Things were looking good a couple of months back; now, every since Eurozone, they are really worrying me. Second leg down? I think we might be sc***ed.
19. May 2010 at 07:48
I’m not using oil alone as the example of commodity prices is broad enough. In the same BLS report it showed increases of 5.2% in steel, 8.4% non-ferrous metals, 2.4% organic chemicals, 4.5% lumber, 11.4% resin, etc., etc.
As a whole “intermediate goods” are up 4.6% (annualized).
I am not saying that is absolute proof of something, but it might be worth looking into before concluding everything must be OK because oil is OK.
I’m 100% in agreement, that the E/USD exchange rate doesn’t, in and of itself, tell us the broader story on what is happening. I think that is an important point.
I also think focusing on oil as a kind of reference point is a bit touchy, because oil may fall and rise for reasons which have nothing to do with the overall strength of the currency. That is, the price of oil may change and not tell use the broader story either.
I’m a bit closer to viewing them all as relative prices, bobbing along against each other, where you can’t take unambiguous conclusions by comparing them amongst themselves.
19. May 2010 at 07:48
But why is UK inflation so high?
19. May 2010 at 08:41
@ Nick Rowe:
Q: “But why is UK inflation so high?”
A: Absolutely massive QE
They cut to 0.5% interest and when that didn’t work they eased out £200bn.
That is roughly 10% of their entire GDP in QE.
It didn’t really seem to help them, though:
BBC says:
‘The UK has exited recession, but was the last major economy to do so, and the 0.1% growth recorded for the final three months of 2009 was unconvincing’
http://news.bbc.co.uk/2/hi/business/7924506.stm
19. May 2010 at 08:44
@Nick:
Forgot to mention I have an acquaintance who is a loan officer at a bank in the UK. He was telling me about people he sold to who refinanced to 0% (yes zero percent) interest housing loans.
19. May 2010 at 09:13
Scott,
I don’t believe you mentioned the gold price — traditionally the measure of absolute value of a currency.
The gold price is a hedge whose present value discounts all future inflation. It is the longest duration asset in existence, so “all future” means “all future”. BTW, gold has zero “self haven” hedging ability outside of inflation protection. In every instance where markets fear instability or future credit problems/deflation, currency is a far better hedge than gold. Therefore, can we agree that outside of immaterial (over the long run) jewelry cycles, gold is only an inflation hedge, and it is the best inflation hedge?
If we can agree on the status of gold as an inflation hedge, then why is it rising when the cpi is falling? The logic is simple: the more the Fed needs to do to battle deflation, the more risk that it will tip us into hyperinflation somwetime in the the future. A double-dip, for instance, would almost certainly lead to further Fed asset purchases, and probably to the adoption of measures that raise inflation expectations directly (i.e. an inflation target). Thus, real growth is the enemy of the gold price (as it will eventually lead to a normalization of monetary policy), deflation risk its friend (as it guarantees the Fed will try to shift inflation expectations upward).
19. May 2010 at 09:25
Scott,
I wanted to add the prices of commodities are governed by 1) the absolute value of the currency and 2) the real demand for the goods. Therefore, a sustained period of gold rising in absolute terms even while commodities fall in price implies that markets expect Fed monetary policy to raise NGDP, but to fail in preventing RGDP from falling.
19. May 2010 at 11:02
Nick:
“I think we might be sc***ed.”
Is that a professional opinion?
ssumner:
One challenge to using knee jerk monetary policy is massive trade oscillations, causing risk premia that are depressing investments (esp. long term). The so-called “moving wall of liquidity” is having real effects on the real economy. There’s a point where the coordinated firepower in a market (due to leverage) becomes sufficient that it causes a market to stop operating like a normal liquid market, and more like a poker table.
This is something that is different and separate from other monetary policy issues, which I’ve agreed that a self-targeting futures system would help address.
It also seems that many of the right wingers who are arguing vociferously for reduced liquidity injections by central banks are also profiting handsomely from their short positions. Funny, that.
19. May 2010 at 12:30
FYI — the 1 year TIPS spread is around 0.50% today, down 1.00% from March and 0.25% from yesterday. The longer durations have been a lot more stable, so Bernanke will conclude that ‘flation expectations are properly anchored.
19. May 2010 at 12:34
Gold does not go to $1200 for the fun of it. And there is no supply-side issue. Inflation can come from high utilization of resources but it can also come from a decline in confidence in fiat money (ask South America about it). Inflation from the latter can occur almost instaneously and without warning as confidence in a currency is almost binary. Gold is telling us that we are closer to that line than we think even no there is now way of modeling it or observing it.
To me this is reminiscent of the (compelling) arguments for taking action against global warming. Even though the environoment today presents no issues we are well aware there is a line that once crossed may create a self-reinforcing disaster. Yet we dont know where tha line is.
The Fed will cross the line….just a question of when.
19. May 2010 at 13:22
[…] of all this, Scott Sumner has done a fantastic, education and counterintuitive job of it here. Has the euro got weaker in the last few days? If only – it has got stronger – just […]
19. May 2010 at 13:47
Scott,
It says something about the power and clear expression of your ideas that your view on the Euro falling against the dollar is one I had almost immediately after learning of these relative changes.
19. May 2010 at 14:19
“Consumer inflation vanishes, a boon for borrowers” (Assoc. Press)
http://news.yahoo.com/s/ap/20100519/ap_on_bi_go_ec_fi/us_economy
Gosh, that’s nice to know.
19. May 2010 at 15:15
Another piece of the puzzle is core eurozone bond yields. If one looks at 10-year bond yields for Austria, Belgium, Finland, France, Germany, Luxembourg, Netherlands and Sweden you will observe that all have fallen by about 70 basis points since last June and about 30 basis points in just the last three weeks. For example the German 10-year bond was trading at only 2.78% as of today. I take this as a sign of falling inflation expectations in the eurozone.
19. May 2010 at 16:21
Correction: Sweden of course is not in the eurozone. Must be premature senility.
19. May 2010 at 17:09
jsalvati, I agree.
DanC, I think there may be a bit of truth in what you say. it might have impacted certain regions and sectors of the US economy, and that could have slowed the economy modestly in mid-2008. Then monetary policy went off course as they worried more about inflation than falling NGDP, and the modest slowdown became severe.
You asked:
“I am interested in your views on the ban on naked shorts.”
On par with banning witchcraft.
Nick, I like the first point. I was going to jump on the second point, until you pointed out that there dilemma was self-inflicted due to interest rate targeting.
On the last point, it is awkward for me to make predictions here because the thing I am worried about (a double dip) is actually not that likely. My complaint is that the Fed has needlessly let the odds rise from 5% to 20%.
ThomasL, Those are not the relevant numbers. Unless I am mistaken those are April numbers in the BLS report. But even oil prices were very high in April. I was pointing to the deflation in commodity prices during May, as a result of the Greek situation. I’d need to know what happened to those prices in May. I’m not saying you are wrong, it’s just that you don’t have the right data to show that deflation risks haven’t increased in the past 3 weeks.
Here’s another way of making my point. If you use old BLS data for April, look at the entire CPI–no reason to single out particular commodities. If you do single out commodities, use today’s prices, not last months. As recently as April the world recovery was on track and Asia was booming. I think it’s very possible you’ll be right and the world will get back on track, but the recent data is a bit worrisome.
Nick#2, I had thought they were more expansionary than the ECB, and the pound had depreciated long before the euro. This would have shown up sooner in the broader price indices. But I haven’t followed the UK, and may be wrong.
Doc Merlin, You may be right. FWIW, my take is that the real shock in the UK was much more severe than in Germany. The UK’s strength is finance while Germany’s strength is exporting machines to China. So they needed a more expansionary monetary policy to have roughly the same fall in RGDP as in Germany. This would then produce higher inflation than Germany. But again, this is a guess based on snippets of information.
David Pearson, Gold is partly an inflation hedge, but rises on both higher average inflation expectations, and wider dispersion of forecasts for inflation. But right now two other factors are at work. Major supply pessimism has developed in the last two years–there don’t seem to be new discoveries occurring. And the booming middle classes of India and China traditionally like gold–and can now afford it. Gold is rising with other commodities–on Asian demand. (The last few weeks the Greek crisis may have led to more demand on currency uncertainties.)
Statsguy, I think you have very good intuition here. But never lose sight of how many of these psychological problems have their root causes in the earlier monetary tightness, relative to the needs of the economy. I.e. tight money one year creates a situation where it looks like easy money won’t help, or easy money will destabilize other variables. But those appearances may be misleading, as the tight money also is creating the very shocks that make easy money more difficult to implement.
JP, Yes, but the longer maturity TIPS spreads are also falling somewhat, just not as fast. The 5 year is under 1.8% and the 10 year is close to 2%. And don’t forget the probability distribution is skewed right (is that the right term?) I.e. 10% inflation is far more likely than 6% deflation under a fiat money regime. This means that an expected value of 2% may co-exist with a modal value of 1.5%. Those who are better at stat can tell me if my terminology is incorrect.
mlb, Even if you are right, and I’m not at all sure you are, 3% inflation over the next 5 years would dramatically reduce the risk of hyperinflation later. Why? Because it would lead to a much quicker recovery and shrink the deficits much faster. Monetization of the debt is the only thing that could produce Latin American style inflation, and we aren’t there yet.
The tight money of 1929-33 led to big deficits and dollar devaluation that was the root cause of the post-WWII inflation.
Thanks Mike.
Statsguy#2, Very funny article. Like William Jennings Bryan said: “You shall not crucify lenders on a cross of gold.” Or was it borrowers?
Mark, Good point—I wish I had known that. Lower long term yields often correlate with slower expected NGDP growth. Not always, but you don’t usually get 2.78% long term yields in countries with Australian-style NGDP growth.
19. May 2010 at 18:20
“There’s a true paradox here. Bernanke wants (or ought to want) people to fear inflation. Yet he also wants to argue that the risk of inflation is very low, which is why he needs to keep interest rates low. His only way out of the paradox is to make an argument which is very convincing to people inside the Fed, and is seen by outsiders to be very convincing to people inside the Fed, but is at the same time totally unconvincing to people outside the Fed. Not an easy task.
And that paradox comes solely from the fact that monetary policy is framed in terms of a time-path for a nominal interest rate.”
I’m not sure why it wouldn’t work to have short term rates very low and 10yr rates 4% to 5%. What you want is to give an incentive for investing in stocks and longer term bonds and corp bonds, and a disincentive to invest in low interest paying short term bonds.
The 3% range has done some good, but not enough. More QE and more borrowing might have led to the 4% to 5% range. If you believe in QE and a Reinforcing Stimulus, the idea is to bring on the fear among the worrier types. That’s how the world works. We face paradoxes and two-edged swords.
In any case, to the extent that we’re not talking about actual expectations and incentives, I assume we’re talking about things that are meant to influence actual expectations and incentives. These are not mechanical operations, so the amounts needed could vary over time and over countries. You have to see how it really works in practice. Of course, you won’t truly be able to tell if it’s working or not. But, again, that’s the deck.
20. May 2010 at 04:37
Don, I agree with you that that might “work”, but I think Nick’s point is that you can’t create that outcome merely by manipulating short term interest rates. You need some other tool (QE, inflation targets. etc.)
Since you also mention QE, I don’t think we disagree.
20. May 2010 at 14:39
@David:
‘BTW, gold has zero “self haven” hedging ability outside of inflation protection. In every instance where markets fear instability or future credit problems/deflation, currency is a far better hedge than gold. Therefore, can we agree that outside of immaterial (over the long run) jewelry cycles, gold is only an inflation hedge, and it is the best inflation hedge?’
That is a good point! However it doesn’t protect against price inflation it protects against any future monetary expansion. If price inflation is caused by an adverse AS shock, then gold is a particularly BAD hedge. This is true even in a stable price environment
21. May 2010 at 05:53
The main beneficiaries of a stable 2% low inflation are financial markets. If prices go up, it’s safer to re-invest profits in the real economy (that is, increasing real investments which are the engine of long-term economic growth) because, at the end, you may sell goods at higher prices. It’s safer because you may end up with lower profits if costs rise more than price, but the difference cannot be huge. Price stability make investing in financial markets the safer option because it increases the opportunity cost associated with financial gains even taking into consideration market volatility -especially if the financial sector is ‘guaranteed’ by governments and monetary authorities in case of a systemic crisis like it’s happening right now.
The problem is that, as a consequence of the lat 20 years of price stability, financial liberalization, and governments’ implicit insurance of banking and financial sectors, financial investments have crowded out real investments in the center -US, Japan, Europe-, while, in the periphery, real investments boomed generating productivity gains and, hence, long-term economic growth.
It’s not exclusively the lower cost of labour which drive capitals towards China and India -like it was not land abundance which drove capitals from Great Britain towards the US at the beginning of the 20th century-, it’s the prospect of economic growth caused by rising real investments, productivity gains, rising standard of living (wages), and, last but not least, rising prices.
Rethink again about the real estate bubble before it exploded. Inflated prices created more production and more jobs. The problem was not that prices were raising, but that were rasing because speculation and through debt leverage.
As Keynes once noted for deflation, inflation doesn’t mean that all prices raise at the same rate. Some prices goes up, some prices goes down and skilled entrepreneurships use these information in order to invest in those sector where profits are raising, that is, where prices rise more than costs. Those extra-investments, however, generates extra-profits through productivity gains.
If prices don’t rise, it’s better to invest in the financial markets, it’s better to gamble, especially if everybody is doing the same -that is, exploit the bubble and wait for the government to intervene if things goes wrong.
22. May 2010 at 04:11
Nick (if you’re still reading this post): Half of UK inflation is an effect of January’s VAT rise – taking that out, it’s only about 2%.
This is still a bit higher than we’d expect given the level of economic activity. The remainder probably does come from QE and the weakness of the pound relative to the dollar and euro.
Finally, the UK economy is genuinely recovering – our first releases of growth statistics are annoyingly inaccurate, but I think that in the current quarter, we may well be growing at an annualised 2.5% or even 3%. With 0.4% growth for the last two quarters, it would not be a surprise to see 0.6% or more this time; and the public deficit has just been revised down from £177bn to £152bn. Both good signs, and both substantially assisted by QE. Because unemployment has not risen much compared to previous recessions, there is less spare capacity to hold down inflation.
22. May 2010 at 07:25
Stearm, You said
“The problem is that, as a consequence of the lat 20 years of price stability, financial liberalization, and governments’ implicit insurance of banking and financial sectors, financial investments have crowded out real investments in the center -US, Japan, Europe-, while, in the periphery, real investments boomed generating productivity gains and, hence, long-term economic growth.”
Is this “the problem” or the solution to vast income inequalities around the world? But I also question your facts. I thought it was the opposite—China was in net terms lending money to the US, and the US had too much real investment and China had too little. (Of course the US also had the wrong sort of real investment.)
Leigh, Thanks for that info–it definitely clears up some of the questions asked by Nick.
24. May 2010 at 07:27
Forget the economic forecasting and remember that two things really drive the economies of both the Euro and dollar. Consumer buying(confidence)and product supply(production). Both are subject to the whims of oil prices (unknown catalyst or monkey wrench) and the availability of raw materials (supply). Greed and price fixing in the form of unchallenged mergers as well as insider trading and excessive corporate lobbying adversely effect the middle class.(if there is one left). How much more simple can it be?
25. May 2010 at 08:17
Rodrian, It’s not that simple–expectations matter.
28. October 2011 at 04:38
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