Overview and Definitions
The value of the dollar should continue its directionless ways, the U.S. economy should maintain low growth, and the Fed should remain accommodative, according to the latest Wells Fargo analysis.
The U.S. current account, the difference between exports and imports of goods, services and transfers, was strengthened in the 1990s by autonomous capital inflows. Autonomous capital flows are taken in response to current prices, exchange and interest rates, and other economic factors by independent actors. These inflows strengthened the dollar. High levels of autonomous inflows seem unlikely as long as the Fed is accommodative, which it will be as long as economic growth and inflation are low.
The dollar’s depreciation was slowed in the last 10 years by accommodating inflows, which are undertaken by central banks for the purpose of settling balance of payments imbalances (the measure of currency flows out of and into a country, where positive means autonomous flows are positive) arising from autonomous flows. Accommodating inflows usually take place as U.S. Treasury securities purchases, and the sum of autonomous and accommodating flows equals zero by an accounting identity.
Three Dollar Phases
From 1995 to 2002, the trade-weighted value of the dollar rose 40%. Trade-weighting adjusts currency values based on the extent of their use in international trade. Gross capital inflows rose more than gross capital outflows as autonomous purchases of U.S. assets increased. The dollar strengthened from the demand for its use for the purchase of the assets. The increase in the financial account surplus was offset by the increase in the current account deficit.
From 2002 to 2008 the dollar declined and was volatile as the financial crisis set in, strengthening from an international flight to safety. The current account reached 6% of GDP in 2006 as high U.S. demand brought in foreign imports at same time that Western Europe and Japan decreased their imports of U.S. goods as their economies weakened. Demand for dollars fell and the currency depreciated.
Capital inflows during this period switched from the autonomous purchases of the previous period to accommodating purchases of U.S Treasury securities by foreign central banks. China in particular heavily intervened to slow the dollar’s depreciation to maintain U.S. imports of Chinese goods. Autonomous transactions decreased from 70% of gross capital inflows to 40% in 2004 (it would appear that an increase in autonomous inflows is a symptom of, and not necessarily a direct cause, of the relative attractiveness of U.S. assets and hence is not the primary cause of dollar appreciation, though it does contribute in its role in the self-perpetuating process.)
From 2009 to today the dollar has been largely directionless. The current account is back down to 2002 levels, but autonomous inflows have not picked up. Accommodating purchases by central banks are nearly double the amount of autonomous purchases of U.S. assets. As U.S. interest rates have remained low, foreign deposits in American banks have decreased. This means that foreign holders of dollars are selling dollars and buying other currencies, which weakens the dollar.
Update 7/23: Foreign investors are buying U.S. Treasuries at the slowest rate since 2006. Foreign investors, however, include U.S. hedge funds that are legally in the Caribbean. This will tend to push interest rates higher barring increased Fed purchases. This is happening at the same time that foreign central banks are decreasing their holdings and the Fed is talking about the possibility of decreasing the QE program. China, however, has increased its position by 7.8% this year. It holds $1.32 trillion. The Fed increased its holdings by 18% to $1.96 trillion.
