Why Intervention to Support the Dollar Remains Unlikely

The U.S. dollar has fallen sharply in recent days. It has reached new record highs against the euro and Swiss franc. It has fallen below the JPY100 level for the first time since 1995. At the same time oil and gold have raced to new record highs. News reports, citing analysts at a couple of large investment banks, say the intervention watch has begun. It is not clear what being on intervention watch entails, especially when neither the analysts themselves nor the price action itself suggest that intervention is perceived to be imminent.

While the risk of intervention is above zero, there are a host of factors suggesting that the probability remains extremely low. The US dollar’s firmer tone for a few hours before the weekend was not indicative of a genuine fear of intervention as its quick reversal illustrates.

We suggest it is most helpful to think about intervention as an escalation ladder. The low rungs on the ladder are different types of verbal intervention. Official commentary at this juncture from the US, Europe and Japan suggest a slight increase in the level of concern, but not nearly enough to suggest that intervention is even being considered.

The case against intervention is compelling. The dollar’s decline has not reached a pace or level that is particularly worrisome. The decline has been fairly orderly and fundamentally based. Given the fundamental backdrop, it is not clear that even coordinated intervention would have a lasting impact, especially if it does not signal a policy adjustment to reinforce the intervention.

Some argue that the markets are in a vicious cycle. That a falling dollar boosts commodity prices, like gold and oil, which in turn weighs on the dollar. There might be an element of truth in this, but it is not clear that a more stable dollar would check the rally in commodity prices. Can US officials be that concerned about oil prices when they insist on still buying crude for the strategic reserves even as the price holds above $100 a barrel? The rally in the price of grains appears to be a function of government policy (ethanol) and poor harvests elsewhere, with low stock levels.

The fact that the G7 reserves are paltry compared with the size of the foreign exchange market is not a key factor in our assessment that intervention is unlikely. It is true that G7 reserves, largely dollars, stand near $1.2 trillion, almost 80% of which is accounted for by Japan, while the Bank for International Settlements estimates daily turnover in the foreign exchange market to be near $3.2 trillion.

But G7 reserves have always been smaller than the daily volume in the foreign exchange market and that did not preclude intervention in the past. The last time the G7 coordinated intervention was in the fall of 2000 when the dollar was sold and the euro bought. Some might argue that dollar buying intervention is different than dollar selling intervention. The last time there was intervention to support the dollar was in the spring of 1995 and with the benefit of hindsight, the intervention appears to coincide with the dollar carving out a bottom that lasted until very recently.

Yet there has been the rise of new significant players in the foreign exchange market since those days: sovereign wealth funds. Their activity in the foreign exchange market is not very transparent and is often the subject of rumors and speculation. Imagine a situation, in which the G7 intervene and succeed in pushing the dollar higher. What prevents foreign central banks or sovereign wealth funds from taking advantage of the higher dollar level to sell? Previously many critics depicted intervention as a transfer of wealth from central bank to speculators. Now it potentially would be a transfer of wealth from the G7 to sovereign wealth funds.

Press reports covering the “intervention watch” story do not discuss this or for the most part discuss the contradictory message the intervention, even if successful, would send to countries like China and the Middle East, who the IMF, the G7 and the US have waged a persistent campaign to allow market forces to determine the value of their currencies. Intervention to support the dollar would be cited by critics, along side the apparent reluctance to mark to market and free-trade as something the G7 wants from others, but refuses to do themselves. To that extent, intervention would obscure the U.S. and G7 strategic interest for the possibility of some tactical gain.

Even though the data on purchasing power parity that the IMF uses shows that the U.S. dollar has not been as under-valued against the European currencies as it is today, as of last September it was still saying the dollar was over-valued. The case for intervention now needs to be built and a statement by the IMF at next month’s meeting that the dollar is no longer over-valued would be a step in that direction.

Ultimately, the key hurdle for intervention is will. And the will is not there. The Bush Administration is the only Administration since before the end of the Bretton Woods regime not to intervene in the foreign exchange market. To get his Administration to authorize intervention would seem to require clear evidence that the weaker dollar was causing the US real direct harm. It is hard to find that at the moment. Some think that such a channel might be US asset markets, but US bonds and stocks are faring better than most others in the G7. To the extent that the falling dollar is impacting the US economy, it seems to be helping exports on the margin (which admittedly is more likely to be a function of growth differentials than the recent decline in the dollar, given the J-curve lags).

The actual direct harm being inflicted on the euro-zone is also difficult to pin down. The most recent trade figures from Germany and France showed unexpected strength in exports. If the euro-zone wants to check the euro’s rise, it has the power to do so. Let ECB President Trichet describe the euro’s rise as “brutal” and to say that the currency’s rise will exacerbate the policy dilemma and does little to really rein in prices. It would seem that if the euro-zone was sufficiently concerned about the euro’s strength they could cut rates or signal that they would consider cutting rates.

Given the modus operandi of officials, other measures will likely be explored before actual material intervention is seriously contemplated. So on the most abstract level, yes the risk of intervention has risen, from near zero to slightly above zero.

The odds of a successful operation would increase, if 1) the IMF said the dollar was no longer over-valued, 2) the negative impact of a falling dollar became more acute and destabilizing, 3) the market suspected that policy in the US and/or Europe was about to change. None of these conditions have been met and therefore, intervention watch is a talking point that lacks substance.