No surprises in Friday’s GDP numbers as all were in line with or very close to street consensus estimates. The final read of Q4 2010 GDP indicates that the economy grew at a pace of 3.1%. Although today’s data were encouraging, there are concerns that higher energy prices and the aftermath of global events could erode consumers’ purchasing power, slowing down the pace of the economic recovery.
One economist told Bloomberg News:
“We’re seeing the effects of rising gasoline prices and we’re going to see a negative impact from the earthquake start to show up because of bottlenecks in the global supply chain. Recent data suggests the expansion is a little softer than anticipated.”
The lower than expected University of Michigan Confidence data indicates that consumers are being squeezed by higher food and energy prices. The report is more distressing than it may appear. This is the Final read of the March data. The prior 68.2 was a preliminary report of March data. The February data indicated a index number of 77.5. That is quite a drop between February and March. Today's index of 67.5 was the lowest read of University of Michigan Confidence since a report of 67.4 in November 2009.
There has been renewed interest in forecasting when the Fed will raise the Fed Funds rate. What many people fail to realize is that the Fed can (and probably will begin to change monetary policy without raisin the Fed Finds rate. That will probably come next year. How and why can the Fed begin to change monetary policy without raising rates? I will try to explain.
First, one must understand the Taylor Rule. Simply stated, the Taylor Rules indicates how much a central bank should raise or lower interest rates in response to the divergence of actual inflation rates versus target inflation rates or, in the case of the Fed which does not have an official inflation target, the divergence of the prevailing rate of inflation versus the desired rate of inflation (believed to be in an approximate range of 2.0% to 2.5%).
Using the Taylor rule as a guide, the Fed Funds rate should be in negative territory. However, since the Fed Funds rate cannot be negative (borrowers cannot be paid to borrow money), the effectively lower interest rates, the Fed has engaged in quantitative easing. The result is that short-term interest rates are effectively below zero. This is what Mr. Diclemente means when he says: “asset purchases and commitment language together are the equivalent of lower overnight rates.”
Although the street consensus forecast calls for the Fed to leave the Fed Funds rate unchanged until early to mid 2012, this does not mean that the Fed will not move to a tightening bias. Here are examples of Fed tightening other than raising the Fed Funds rate:
1) Letting QE2 run its course by June and not engage in QE3.
2) Selling its bond holdings. The Fed does not necessarily have to sell its holdings outright. It can engage in reverse repos (A.K.A. reverse repurchase agreements). In a reverse repo, the Fed temporarily sells securities to counterparties with the intention of repurchasing at a later date at a predetermined price. By executing reverse repos, the Fed can temporarily remove money from the system. This effects a Fed tightening without reducing the size of its balance sheet. The Fed can engage in reverse repos (or repos for that matter should it want to add money to the system) enabling it to fine tune policy to economic conditions. The Fed tested the waters and executed a small amount of reverse repos yesterday to test the waters.
3) Jawboning: The Fed could and probably will begin to use language hinting at a less accommodative policy stance. That usually causes market participants to change their trading or investment strategies. The usual result is higher short-term yields. Note: Long-term yields often do not respond in kind (and sometimes remain little changed or even fall) in response to Fed tightening, resulting in a flattening yield curve.
The point I am trying to make is that raising the Fed Funds rate is not the only way, and probably will not be the first way, in which the Fed removes stimulus from the system. Those who are waiting for actual short-term rates to rise may have to wait at least another year before that happens.
Investors should not myopically view higher short-term rates as the Fed’s only method of moving to a tightening bias. They should also be cautioned against making the mistake of believing that higher short-term rates automatically equates to higher long-term rates.
The goal of higher short-term rates is to quell inflation. If inflationary pressures are abated, there would little reason for long-term rates to rise very high. If the Fed is successful, we could see a scenario in which the halt and reversal of quantitative easing accomplish much of the desired inflation abatement and could be followed by only a modest Fed Funds rate increase. Assuming the Fed will be successful in combating inflation, long-term rates during the forthcoming interest rate cycle may also peak at levels below to what we have become accustomed.
The street consensus is in line with this scenario. Here are the Q2 2012 street consensus estimates for interest rates across the yield curve as compiled by Bloomberg News among at least 40 respondents per area of the yield curve.
Fed Funds: 1.00%.
Three-month USD LIBOR: 1.25%.
Two-year Note: 1.95%.
Ten-year Note: 4.25%
Thirty-year Bond 5.25%.
Although the forecast is for higher rates across the curve, the forecast does not call for extraordinarily high interest rates. Considering that QE has effective policy interest rates below zero, a Fed Funds rate of 1.00% may have a similar effect as a 200 basis point (or more) Fed Funds rate increase had during previous interest rate cycles. Where will the Fed Funds peak during the next cycle? It is too early to even forecast, but given the relatively weak economic underpinnings and the slow pace of the recovery, Fed Funds rates may not have to be very high to rein in inflation. It is not inconceivable that the Fed Funds rate peaks at 3.00% or less during the next interest rate cycle.
Last year, a well-respected economist cautioned me that the absolutes during this recovery, including interest rates, could be lower than to what we have become accustomed. In such a scenario, staying overweighted in cash or focusing one’s portfolio in short-term benchmark floaters could be a poor strategy. However, because only relatively-small long-term rate increases are necessary to result in sharp price declines in long-duration securities, one may not wish to overweight the long end of the curve. As is common in life, the answer may lie in the middle.
The belly of the curve, between three five and ten years, may offer the best returns on a risk / volatility-to-reward basis. Our suggestion to investors would be to not try to time the markets, peg a specific area of the curve or focus on a product which may outperform should market conditions play out in a specific fashion and structure a diverse portfolio which should perform well under a variety of market conditions.
Sunday, March 27, 2011
Friday, March 18, 2011
A Quick One
Since the beginning of February the yield (interest rate) if the 10-year U.S. treasury note has fallen from about 3.73% to approximately 3.25%. The markets are more fearful that higher oil prices will quash the nascent recovery more than they fear higher prices throughout the economy. The correlation between higher oil prices and lower 10-year yields is very close.
Tuesday, March 15, 2011
The Ides Have It
www.mksense.blogspot.com
Foreign purchases of U.S. securities fell in January as overseas investors sought to diversify their holdings. However, purchases of U.S. treasuries held up fairly well. China, the largest holder of U.S. treasuries, reduced its holdings of U.S. treasuries by $5.4 billion to $1.15 trillion. Japan, the second largest holder of U.S. treasuries, increased its holdings of U.S. by $3.6 billion to $885.9 billion. It should be noted that this data is from January and does not include the very strong treasury auctions (including a record 10-year note auction) which occurred in February. Some market participants have expressed concerns that Japanese insurers could sell some of their U.S. treasury holdings to pay claims.
The market is taking that possibility in stride as the U.S. dollar and U.S. treasuries remain the world’s safe haven in times of turmoil. Also, approximately 93% of Japan’s government debt is held by Japanese investors, including Japanese institutions. It is just as possible that institutions sell Japanese debt to pay for claims.
When Fed governor Kevin Warsh vacates his post later this month, he will be the latest of Fed Chairman Ben Bernanke’s so-called “inner circle” to leave the Fed. However, Mr. Warsh expressed concerns that implementing QE2 came with possible unintended consequences. This caused Fed watchers to wonder if the relationship between Mr. Warsh and Mr. Bernanke were irreparably damaged. Mr. Warsh’s departure follows those of former vice chairman Donald Kohn and former New York Fed president Timothy Geithner, who left to become treasury secretary. In their place are former San Francisco Fed president Janet Yellen, who is taking over as vice chairwoman and current New York Fed president William Dudley. Both Ms. Yellen and Mr. Dudley supported QE2 and are considered to be dovish with regards to inflation.
The New York Fed is considered to be the most influential of the regional Fed banks. This gives the accommodative Mr. Dudley a relatively loud voice with regards to Fed policy. As vice chairwomen, Ms. Yellen can be expected to have the ear of chairman Bernanke. Some believe that the new makeup of the Fed makes it more likely that the Fed will follow through with its QE2 purchases and be very cautious when considering raising the Fed Funds rate.
Inflationary concerns have been lessened during the past four trading sessions as the earthquake in Japan and the resulting nuclear problems have market participants concerned that Japan’s economy will be impaired by the disaster, reducing the demand for energy products and raw materials (although Keynesians may be of the opposite opinion, Toyota, Nissan and Honda have shut down assembly lines in Japan which is not good for the Japanese economy). Crude oil is down $2.61 today to $98.58. Of course it could be that speculators are taking some of their profits off the table.
If there is a lesson to take away from recent market performances, it is that we should expect the unexpected. The question remains about whether or not the economic recovery is strong enough to withstand disruptive global events. Whether or not it can remains to be seen, but one would probably get few arguments if one opined that the recovery would not be able to withstand recent events if the Fed had already begun to remove stimulus.
No surprises from the FOMC today. As expected, the Fed Funds rate remains at 0.00% - 0.25% and the Fed remains committed to following through on QE2. The FOMC language was cautiously optimistic, also as expected. Here is a copy of the FOMC text:
Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.
Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer- term inflation expectations have remained stable, and measures of underlying inflation have been subdued.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. The Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization. subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.
Tell your friends. I am looking for more subscribers.
Foreign purchases of U.S. securities fell in January as overseas investors sought to diversify their holdings. However, purchases of U.S. treasuries held up fairly well. China, the largest holder of U.S. treasuries, reduced its holdings of U.S. treasuries by $5.4 billion to $1.15 trillion. Japan, the second largest holder of U.S. treasuries, increased its holdings of U.S. by $3.6 billion to $885.9 billion. It should be noted that this data is from January and does not include the very strong treasury auctions (including a record 10-year note auction) which occurred in February. Some market participants have expressed concerns that Japanese insurers could sell some of their U.S. treasury holdings to pay claims.
The market is taking that possibility in stride as the U.S. dollar and U.S. treasuries remain the world’s safe haven in times of turmoil. Also, approximately 93% of Japan’s government debt is held by Japanese investors, including Japanese institutions. It is just as possible that institutions sell Japanese debt to pay for claims.
When Fed governor Kevin Warsh vacates his post later this month, he will be the latest of Fed Chairman Ben Bernanke’s so-called “inner circle” to leave the Fed. However, Mr. Warsh expressed concerns that implementing QE2 came with possible unintended consequences. This caused Fed watchers to wonder if the relationship between Mr. Warsh and Mr. Bernanke were irreparably damaged. Mr. Warsh’s departure follows those of former vice chairman Donald Kohn and former New York Fed president Timothy Geithner, who left to become treasury secretary. In their place are former San Francisco Fed president Janet Yellen, who is taking over as vice chairwoman and current New York Fed president William Dudley. Both Ms. Yellen and Mr. Dudley supported QE2 and are considered to be dovish with regards to inflation.
The New York Fed is considered to be the most influential of the regional Fed banks. This gives the accommodative Mr. Dudley a relatively loud voice with regards to Fed policy. As vice chairwomen, Ms. Yellen can be expected to have the ear of chairman Bernanke. Some believe that the new makeup of the Fed makes it more likely that the Fed will follow through with its QE2 purchases and be very cautious when considering raising the Fed Funds rate.
Inflationary concerns have been lessened during the past four trading sessions as the earthquake in Japan and the resulting nuclear problems have market participants concerned that Japan’s economy will be impaired by the disaster, reducing the demand for energy products and raw materials (although Keynesians may be of the opposite opinion, Toyota, Nissan and Honda have shut down assembly lines in Japan which is not good for the Japanese economy). Crude oil is down $2.61 today to $98.58. Of course it could be that speculators are taking some of their profits off the table.
If there is a lesson to take away from recent market performances, it is that we should expect the unexpected. The question remains about whether or not the economic recovery is strong enough to withstand disruptive global events. Whether or not it can remains to be seen, but one would probably get few arguments if one opined that the recovery would not be able to withstand recent events if the Fed had already begun to remove stimulus.
No surprises from the FOMC today. As expected, the Fed Funds rate remains at 0.00% - 0.25% and the Fed remains committed to following through on QE2. The FOMC language was cautiously optimistic, also as expected. Here is a copy of the FOMC text:
Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually.
Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer- term inflation expectations have remained stable, and measures of underlying inflation have been subdued.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.
Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. The Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization. subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.
Tell your friends. I am looking for more subscribers.
Monday, March 7, 2011
Treasuries For Sale
For years pundits have warned us that foreign investors, specifically China, were going to look elsewhere for a place to invest their capital. Some have said that low interest rates, a weaker dollar and record budget deficits have resulted in the day of reckoning drawing near. However, data indicates that foreign buying of U.S. treasuries has increased.
Bloomberg News reports:
“Investors outside the U.S. have boosted their holdings of longer-maturity Treasuries to the highest level since the credit markets froze in 2008, helping curb rising yields amid concern inflation is accelerating.”
“International buyers held 90 percent of their $4.44 trillion of U.S. government debt in notes and bonds as of December, the same as in September 2008 when Lehman Brothers Holdings Inc. collapsed, Treasury data released last week show.”
Market participants, such as Pimco’s Bill Gross and Sun Trust’s Andy Richman express views that buying treasuries at these yield levels given that the economy is healing and inflation pressures are building (I think the are overstating here), is unwise. I agree with them Investors would be unwise to buy long-dated treasuries at these levels, but foreign central banks are not investor. They have a different mission.
As I have written ad nauseum, foreign central banks and export businesses are flush with dollars from foreign trade. Central banks are tasked with “managing” exchange rates between their home currencies and the dollar. They have no choice but to buy treasuries. For duration and liquidity purpose, the 10-year note is the vehicle of choice.
Inflation fears are largely overblown. Without wage increases, higher oil prices can only have a limited effect on inflation. In fact, higher oil prices are self-limiting. At some point, cash strapped consumers will be squeezed. First they will defer discretionary purchases. Then they will spend more frugally on necessary items. Then they will cut back as much as possible on fuel purchases. The result will be significant headwinds for the economy, probably not enough to cause a recession, but enough to keep inflation well under 3.00% and GDP under 4.00%.
Bloomberg News reports:
“Investors outside the U.S. have boosted their holdings of longer-maturity Treasuries to the highest level since the credit markets froze in 2008, helping curb rising yields amid concern inflation is accelerating.”
“International buyers held 90 percent of their $4.44 trillion of U.S. government debt in notes and bonds as of December, the same as in September 2008 when Lehman Brothers Holdings Inc. collapsed, Treasury data released last week show.”
Market participants, such as Pimco’s Bill Gross and Sun Trust’s Andy Richman express views that buying treasuries at these yield levels given that the economy is healing and inflation pressures are building (I think the are overstating here), is unwise. I agree with them Investors would be unwise to buy long-dated treasuries at these levels, but foreign central banks are not investor. They have a different mission.
As I have written ad nauseum, foreign central banks and export businesses are flush with dollars from foreign trade. Central banks are tasked with “managing” exchange rates between their home currencies and the dollar. They have no choice but to buy treasuries. For duration and liquidity purpose, the 10-year note is the vehicle of choice.
Inflation fears are largely overblown. Without wage increases, higher oil prices can only have a limited effect on inflation. In fact, higher oil prices are self-limiting. At some point, cash strapped consumers will be squeezed. First they will defer discretionary purchases. Then they will spend more frugally on necessary items. Then they will cut back as much as possible on fuel purchases. The result will be significant headwinds for the economy, probably not enough to cause a recession, but enough to keep inflation well under 3.00% and GDP under 4.00%.
Wednesday, March 2, 2011
"Well the eagle's been flying slow, and the flag's been flying low, and a lotta people say that America's fixing to fall."
There is an interesting article on page C12 of today’s Wall Street Journal by Berkeley Professor Dr. Barry Eichengreen entitled: “Why the Dollar's Reign Is Near an End”. In the article Dr. Eichengreen states that the U.S may have to share its role as the world’s reserve currency with the euro and, eventually, the yuan.
He argues that technology has made it easier to exchange one home currency for another. Previously, determining exchange rates between two specific currencies of smaller countries was not easily accomplished. Now, electronic trading platforms have made FX markets much more liquid and transparent.
He also makes the argument that the euro and the yuan will rival the dollar in the future as the EU and China rise as trading blocs. His theories are based on his belief that the EU and its member countries will become more fiscally responsible and that China will open up its markets, loosen its grip on the yuan and become less of a command economy.
A counter article authored by the Journal's own Michael Crittenden entitled: "The Case for the Dollar's Continued Dominance" discusses why the dollar could remain the world's reserve currency. Many economists interviewed support this belief:
University of Wisconsin economics professor Menzie Chinn states:
"How much of a financial center can they be if they insist on continuing to control the financial sector? Until Beijing frees up its financial markets, who wants to have a lot of assets denominated in renminbi?”
Pimco’s Tony Crescenzi states:
“We try to think of the alternatives, and none exist of any consequence."
Even members of the ECB believe that dollar may still reign supreme. ECB Vice President Vitor Constâncio said, "I do not see a major reform of the international monetary system on the horizon, as there is no real substitute for the U.S. dollar in the medium term."
Like it or not we currently live in a world of fiat currency. A currency’s value is only as strong as the system which issues it. During times of turmoil one does not wish to go to sleep at night and worry that a government may change exchange policies or even collapse altogether overnight. Things look rosy for many emerging market economies, but one still must be concerned about their abilities to deal with inflation and the potential civil unrest which could occur.
China has given us indications of how it will deal with inflation. Basically it isn’t addressing inflation, at least not its causes. For the most part it has ordered (it is a command economy) banks to reduce lending and CNBC reported this morning the China’s government is considering ordering salaries raised so consumers can better afford higher prices. Not exactly steps toward a freely-floating currency. A freely-floating and portable yuan would significantly reduce government control over China’s economy. It would likely reduce China’s comparative advantage in manufacturing.
What about the EU? The EU, as of now, is not a United States of Europe. Although it does have a central bank (the ECB) which dictates monetary policy. Fiscal policy is set by the individual sovereign nations. The EU has no authority over sovereign fiscal policies. This can handcuff the ECB.
The ECB has a single mandate of price stability. However, inflation and economic conditions are not the same throughout the EU. On one hand there is Germany with a booming economy and record-low unemployment. On the other hand there are the PIIGS. Spain has unemployment in the area of 20%, and there is unrest in Greece due to proposed wage and benefit cutbacks to government workers. In a perfect world, troubled EU members would ease monetary policy to reinvigorate economy. However, EU sovereign nations cannot print money. Policies which help reinvigorate the PIIGS could lead to inflation pressures in Germany. Anti-inflation policies designed to keep prices in the stronger EU economies in check could be catastrophic for the PIIGS.
The dollar is not pre-ordained to be the world’s reserve currency. The dynamics of other economies and societies could change in ways which enable their economies and currencies to rival the U.S. However, until those changes are implemented (if they are ever implemented), the dollar will probably remain the world’s reserve currency ("the same as it ever was...").
He argues that technology has made it easier to exchange one home currency for another. Previously, determining exchange rates between two specific currencies of smaller countries was not easily accomplished. Now, electronic trading platforms have made FX markets much more liquid and transparent.
He also makes the argument that the euro and the yuan will rival the dollar in the future as the EU and China rise as trading blocs. His theories are based on his belief that the EU and its member countries will become more fiscally responsible and that China will open up its markets, loosen its grip on the yuan and become less of a command economy.
A counter article authored by the Journal's own Michael Crittenden entitled: "The Case for the Dollar's Continued Dominance" discusses why the dollar could remain the world's reserve currency. Many economists interviewed support this belief:
University of Wisconsin economics professor Menzie Chinn states:
"How much of a financial center can they be if they insist on continuing to control the financial sector? Until Beijing frees up its financial markets, who wants to have a lot of assets denominated in renminbi?”
Pimco’s Tony Crescenzi states:
“We try to think of the alternatives, and none exist of any consequence."
Even members of the ECB believe that dollar may still reign supreme. ECB Vice President Vitor Constâncio said, "I do not see a major reform of the international monetary system on the horizon, as there is no real substitute for the U.S. dollar in the medium term."
Like it or not we currently live in a world of fiat currency. A currency’s value is only as strong as the system which issues it. During times of turmoil one does not wish to go to sleep at night and worry that a government may change exchange policies or even collapse altogether overnight. Things look rosy for many emerging market economies, but one still must be concerned about their abilities to deal with inflation and the potential civil unrest which could occur.
China has given us indications of how it will deal with inflation. Basically it isn’t addressing inflation, at least not its causes. For the most part it has ordered (it is a command economy) banks to reduce lending and CNBC reported this morning the China’s government is considering ordering salaries raised so consumers can better afford higher prices. Not exactly steps toward a freely-floating currency. A freely-floating and portable yuan would significantly reduce government control over China’s economy. It would likely reduce China’s comparative advantage in manufacturing.
What about the EU? The EU, as of now, is not a United States of Europe. Although it does have a central bank (the ECB) which dictates monetary policy. Fiscal policy is set by the individual sovereign nations. The EU has no authority over sovereign fiscal policies. This can handcuff the ECB.
The ECB has a single mandate of price stability. However, inflation and economic conditions are not the same throughout the EU. On one hand there is Germany with a booming economy and record-low unemployment. On the other hand there are the PIIGS. Spain has unemployment in the area of 20%, and there is unrest in Greece due to proposed wage and benefit cutbacks to government workers. In a perfect world, troubled EU members would ease monetary policy to reinvigorate economy. However, EU sovereign nations cannot print money. Policies which help reinvigorate the PIIGS could lead to inflation pressures in Germany. Anti-inflation policies designed to keep prices in the stronger EU economies in check could be catastrophic for the PIIGS.
The dollar is not pre-ordained to be the world’s reserve currency. The dynamics of other economies and societies could change in ways which enable their economies and currencies to rival the U.S. However, until those changes are implemented (if they are ever implemented), the dollar will probably remain the world’s reserve currency ("the same as it ever was...").
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