The US dollar slide has entered early stages of what looks to be a sharp descent, having already fallen by 4.3 per cent in the four months ending in August in terms of its real effective exchange rate – the index that matters the most for trade, competitiveness, inflation and monetary policy.
This recent pullback comes after its nearly 7 per cent surge from February to April, when the dollar benefited from the flight to safety triggered by the Covid-19 economic shock. But even with the recent modest correction, the dollar remains the most overvalued major currency in the world.
I continue to expect this broad dollar index to plunge by as much as 35 per cent by the end of 2021. This reflects three considerations: the rapid deterioration in macroeconomic imbalances in the UNited States, the ascendancy of the euro and renminbi as alternatives, and the end of the aura of American exceptionalism that has given the dollar Teflon-like resilience from most the the post-World War II era.
The first factor – America’s mounting imbalances – is playing out with a vengeance. The confluence of an unprecedented erosion of demestic savings and the current account deficit is nothing short of staggering.
For the first time since 2008-09 global financial crisis, the net national savings rate has entered negative territory, at minus 1 per cent in the second quarter. And it did so at speed, falling by 3.9 percentage points from the previous quarter – the sharpest plunge since records began in 1947.
What triggered this unprecedented savings collapse is no secret. The temporary surge in personal savings sparked by Covid-19 has been more than outweighed by a record expansion in the federal budget deficit.
The Coronavirus Aid, Relief and Economic Security (CARES) Act featured US$1,200 relief cheques to most Americans and a sharp expansion of unemployment insurance benefits. This boosted the personal savings rate to an unheard of 33.7 per cent in April but this quickly receded to 17.8 per cent in July and is set to fall more sharply with the recent expiration of expanded unemployment benefits.
Offsetting this was a US$4.5 trillion annualised widening of the federal deficit in the second quarter (on a net saving basis), to US$5.7 trillion, which swamped the US$3.1 trillion surge in net personal savings.
With the federal budget deficit exploding towards 16 per cent of gross domestic product this financial year, according to the Congressional Budget Office, the savings plunge is only a hint of what lies ahead.
This will trigger a collapse in the US current-account deficit. Lacking savings and wanting to invest and grow, the US must import surplus savings and run massive external deficits to attract foreign capital.
This was confirmed by recently released second-quarter international transactions statistics. Reflecting the savings plunge, the US current-account deficit widened to 3.5 per cent of GDP – the worst since the 4.3 per cent deficit in the fourth quarter of 2008.
This widening of the deficit by 1.4 percentage points from the previous quarter is the largest deterioration since records started in 1960. Like the savings collapse, the current-account dynamic is unfolding in ferocious fashion.
With the net domestic savings rate likely to reach record depths of minus 5-10 per cent of national income, I fully expect the current-account deficit to break its 2005 record of 6.3 per cent of GDP. Driven by the explosive surge in the federal budget deficit this year and in the next, the collapse of domestic savings and the current-account implosion should unfold at near-lightning speed.
It is not just the rapidly destabilising savings and current-account imbalances that are putting downward pressure on the dollar. A shift
in the Federal Reserve’s policy strategy is a new and important ingredient. By moving to an approach that now targets average inflation, the Fed is sending an important message: zero-interest rates are likely to persist for longer than previously thought, regardless of any temporary overshoots of the 2 per cent target.
This new bias towards monetary accommodation effectively closes off an important option – upwards adjustments to interest rates – that has long tempered currency declines in most economies. By default, that puts even more pressure on the falling dollar as the escape valve from America’s rapidly deteriorating macroeconomic imbalances.
In short, the vice is tightening on a still-overvalued dollar. Domestic savings are plunging as never before, and the current-account balance is following suit. Don’t expect the Fed, focused more on supporting equity and bond markets than on leaning against inflation, to save the day. The dollar’s decline has only just begun.