ECONOMY AND POLICY
April 22, 2022
Chief Economist Scott Brown discusses current economic conditions.
Over the years, two questions continue to come up on a regular basis. One is whether the dollar will lose its status as the world’s key reserve currency. The other is whether we are heading into a recession. These questions are showing up more right now, so here goes…
Q1: Will the dollar lose is status as the world’s key reserve currency, and what happens if it does?
The U.S. benefits from the dollar’s position in the global financial system. In the 1960s, former French President Valéry Giscard d’Estaing referred to these benefits as an exorbitant privilege (privilège exorbitant). The U.S. buys foreign goods in dollars; it doesn’t have to convert dollars to the foreign currency. Foreigners readily accept dollars in exchange for goods and are more willing to hold U.S. debt. These benefits are important, but the economic impact is not huge. That is, the U.S. economy would still do okay, if the dollar’s global role were diminished.
So, what would replace the dollar? Not sterling (the British pound) or the euro. The Chinese renminbi (yuan) ought to become increasingly important in global trade, but it’s a highly managed currency and China has strict capital controls.
Could a cryptocurrency replace the dollar? Not likely. Like cryptocurrencies, the U.S. dollar is fiat money. It’s not backed by gold or some other commodity. It is only worth what people think it’s worth. Unlike cryptocurrencies, the value of the dollar is supported by the Federal Reserve. While inflation is currently elevated, the Fed is fully committed to price stability (a long-term inflation rate of 2%). As we’ve seen, the value of crypto currencies can vary widely. Stable coins, which are tied to a specific currency, and Central Bank Digital Currencies (CBDBs) are on their way. These will help to bring financial services to low-income communities and developing nations – but they are not going to replace the dollar.
One could image that, at some point, an incompetent president might nominate (and the Senate might approve) some idiot to run the U.S. Fed -- or that the U.S. could suffer some catastrophe (such as a major rupture of the Cascadia Subduction Zone or a widespread, severe, and prolonged drought) that would significantly damage the U.S. economy, but that’s seems unlikely. The point is that substantial weakness in the U.S. economy would cause the dollar to lose its reserve status, not the other way around.
Q2: Are we in a recession? Are we headed into a recession? When will we have a recession?
The NBER’s Business Cycle Dating Committee (which sounds like a lonely hearts club for two-wheeling nerds) defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” An official declaration of recession depends on the three Ds: the depth, diffusion, and duration of the downturn. Typically, that would require weakness in nonfarm payrolls, real (inflation- adjusted) personal income (ex-transfers), real consumer spending, real business sales, and industrial production. None of these are close to signaling that we are currently in a recession.
The slope of the Treasury yield curve is the single-best predictor of recessions, but it’s not the 2y-10y spread. The shorter end of the curve is the key. Inversion at the shorter end (short-term rates higher than long-term rates) signals that short-term interest rates are expected to decline. Why? Because you’re headed into a recession. The 3m-10y spread is currently about 210 basis points, far from inversion. There are no good predictive models of recession looking a year or more out. It’s subjective, but economists generally put the odds of a recession in the next 12 months at around 25-30%.
Having raised short-term interest rates by 25 basis points on March 17, the Federal Reserve has begun a tightening cycle. Chair Powell and other Fed officials have signaled that a 50-bp hike at the May 3-4 FOMC meeting is a near certainty. The Fed has a long way to go to get to a neutral policy rate (which Fed officials generally see as a federal funds target rate of 2.25-2.50%). Powell has signaled that the Fed is prepared to go beyond that, possibly tipping the economy into a recession, if that is what it takes to get inflation down. The unwinding of the balance sheet, set to be announced on May 4, complicates the outlook.
The late MIT economist Rudi Dornbusch once remarked that economic expansions never die of old age – they are murdered by the Fed. Fed officials are optimistic that the central bank can achieve a soft landing, slowing the economy to a long-term sustainable pace without a recession. Financial conditions (especially mortgage rates) have tightened on the Fed’s forward guidance (of higher short-term rates). Monetary policy will be nimble and flexible in response to incoming economic data. While the odds of a policy mistake (and a possible recession) have risen, that’s not the most likely scenario.
Recent Economic Data
The Fed’s Beige Book noted that “inflationary pressures remained strong,” with “steep increases in raw materials, transportation, and labor costs.” The Russia invasion of Ukraine and lockdowns in China are adding to supply chain disruptions.
Single-family building permits fell 4.8% in March, to a 1.147 million seasonally adjusted annual rate (-3.9% y/y). Single-family starts fell -1.7%. The volatile multi-family sector showed strength.
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Existing home sales fell 2.7% in March, to a 5.77 million seasonally adjusted annual rate (-4.5% y/y). Higher mortgage rates have further reduced affordability, but homes continue to sell rapidly.
Homebuilder sentiment fell two points, to 77, in April. Expectations of future sales conditions sank, reflecting a sharp jump in mortgage rates and persistent supply chain disruptions. The index averaged 67 in 2018-2019.
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Jobless claims were little changed (at 184,000), consistent with an extremely tight job market.
The Index of Leading Economic Indicators rose 0.3% in March, following +0.6% in February, consistent with a continued expansion (that is, we’re not in a recession).
Industrial production rose 0.9% in the initial estimate for March (+5.5% y/y). Manufacturing output rose 0.9% (+5.2% y/y), led by a 7.8% rebound in motor vehicle production (+3.9% y/y).
The opinions offered by Dr. Brown are provided as of the date above and subject to change. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
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