Goldman: "The Dollar Needs To Fall A Lot Further From Here"
In today's note by Goldman's Robin Brook, the analyst takes an inverse approach of looking at what a dollar drop implies for CPI and general prices, in an attempt to settle a debate whether the expected drop in the USD as a result of QE2 will have a meaningful impact on both inflation, currency wars, and other derivatives of monetary policy. As Goldman concludes: "the ‘pass-through’ from Dollar declines to US consumer price inflation
is small. This in turn means that – if indeed the Fed sees the Dollar as
one of its key policy levers for preventing inflation from staying
below its mandate for a prolonged period – the Dollar needs to fall a lot further from here." The quantification of "lot" is not provided but is sufficiently indicative from a qualitative standpoint. Of course, the biggest issue here is with the construction of CPI itself, which is driven far more by a collapse in leveraged input prices specifically as pertains to shelter, then spiking prices in items most see as critical in day to day use. Nonetheless, as Goldman is one of the Primary Dealers whose opinion is now a part of the "reverse inquiry" methodology in determining monetary policy, the fact that the hedge fund is comfortable with a substantial drop in the USD implies that the Fed should be just as comfortable with a shock and awe approach to QE2, as a pronounced effect on the dollar would likely have to come from a stepwise drop as opposed to a gradual wear down which would be intercepted by other central banks. The key question remains: what level on the DXY is Goldman, and thus the Fed comfortable with as ""modestly inflation stimulating, and what will the price of jeans be, gold, and other commodities be, not to mention what the final level of excess reserves and margins for Chinese exporters, once that level is finally attained.
From Goldman Sachs:
Historically, only a relatively small fraction of a Dollar fall is ‘passed through’ into consumer prices. For example, a paper by researchers at the Fed concludes based on data from 1981 to 2000 that a 10 percent decline in the trade-weighted Dollar boosts inflation by only around 30 bps, a very small effect. The small magnitude of this effect reflects a variety of factors, among which perhaps the most important is the desire of foreign exporters to preserve market share in the US, which means that they tend to react to Dollar falls by accepting smaller profit margins rather than hiking prices.
We update this analysis, by estimating a simple but popular Phillips curve specification that relates year-over-year core CPI inflation to the concurrent unemployment gap (measured by the distance of actual unemployment from the Congressional Budget Office’s estimate of the “natural” rate, currently at 5%), inflation expectations (measured by the 50th percentile of the Reuters/University of Michigan survey of longer term inflation), and the current and lagged year-over-year percent changes in the GS broad Dollar trade-weighted index.
We estimate a similar magnitude for the pass-through as the Fed for data through 2000, but when we update the analysis for more recent data we find that the exchange rate pass-through into core CPI has fallen to essentially zero. This decline in pass-through is put down to the changing composition of imports in the academic literature, with the composition of imports changing over time towards goods with low pass-through.
Of course, it is possible that this “partial” effect underestimates the full effect from Dollar weakness on inflation, because it does not account for the fact that a lower Dollar has the potential to boost employment and raise inflation expectations. However, when we try to control for these indirect channels, we still find that the pass-through from the Dollar to inflation is negligible.
At a more fundamental level, it is possible that our estimates – and those in the academic literature – are biased down because – over the sample period – most of the variation in the trade-weighted Dollar has been against other majors, rather than against key emerging markets from which the bulk of traded consumables that go into the CPI are imported. If going forward there is meaningful appreciation of NJA FX against USD – and this is indeed our base case, in which we expect CNY to strengthen 7% against USD over the next 12 months – our estimates could understate the impact of a Dollar fall on CPI.
We thus perform a robustness check, wherein we assume that all apparel and recreation items in the CPI are imported from China, which together accounts for roughly 10 percentage points in the CPI. Allowing for the fact that around 40% of apparel imported into the US are from China and assuming a 100% pass-through (an extreme assumption we make for the purpose of illustration), a 7% appreciation of CNY against USD in this setting would boost CPI by around 30 bps in one year. Making more realistic assumptions on pass-through, the impact on the US CPI is likely to be much smaller than that, in line with our empirical estimates. Therefore, even with significant CNY appreciation, the impact on US inflation is likely to be small.
What all this points to is that – in line with the academic literature – the ‘pass-through’ from Dollar declines to US consumer price inflation is small. This in turn means that – if indeed the Fed sees the Dollar as one of its key policy levers for preventing inflation from staying below its mandate for a prolonged period – the Dollar needs to fall a lot further from here.
Ultimately, core CPI inflation remains hostage to the slowdown in rental (shelter) price and services (less shelter) price inflation – a point we have made repeatedly in our research and one of the main reasons why our bond forecasts have been below the forwards over the past 18-months. These components represent a significant component of the core inflation rate at approximately 31.9% and 28.3% respectively and are typically determined largely by domestic as opposed to external factors. And so as domestic conditions remain depressed, core inflation is likely to remain below levels the Fed would consider consistent with its mandate for some time.
And, indicatively, Goldman does provide a framework for expected dollar depreciation:
We recently updated our estimate of the potential impact of QE2 on GDP growth in yesterday’s US Daily. Taking into account historical linkages and the possibility that a number of the usual transmission channels from financial conditions to growth are likely impaired at present—particularly housing investment—we estimate that $1 trn in asset purchases could be worth about ½ a percentage point of growth. Again, this estimate is subject to a large degree of uncertainty, but if this order of magnitude is right, then the impact of QE2 on growth is hardly earth shattering.
QE2 will of course also have important effects on inflation, not least via Dollar depreciation which should raise import and ultimately consumer prices. It is this external channel on inflation that we now want to focus on, in part because recent interest – as part of the “currency war” debate – has focused on the fall-out of QE2 on the Dollar.
Here, we reverse the question. Instead of asking how much the Dollar might fall because of QE2, we ask how much of a Dollar decline is needed to meaningfully boost inflation in the US. We think that this will help benchmark the Dollar decline we have seen to-date, and also help put in perspective our forecast for a further 5% decline in the Dollar on a broad, trade-weighted basis from here over the next 12 months.
Of course, this particular approach is just one of many ways to benchmark Dollar weakness. As we have previously argued in a Global Viewpoint, the core of our long-standing bearish Dollar view is the need for a rebalancing of the US economy to improve external balances and lower relative real wages.
In other words, look for hard commodities to more than make up for the 5% anticipated drop in absolute purchasing power, and for a far more dire margin warning from the like of Jones Apparel at the next earnings go around.