Short-term Capital, Streaming and Steaming

Emerging economies need to and will likely increase interest rates and tighten capital controls. The G-20 ministerial meeting in Seoul didn't solve any problems. The communique promised that the G-20 countries would not engage in competitive devaluations and limit current account surplus.

But the source of the global currency market instability is the U.S.'s strong preference for using monetary policy to solve economic problems, effective or not, and the dollar is the currency of global trade and for commodity pricing. Political trends in the U.S. are moving in a direction less favorable to the strength of the dollar and, hence, the global currency market instability.

The Republican Party is likely to win control of the House in the November mid-term elections. With the Democrats in control of the Whitehouse and the Republicans, the House, no meaningful policy can be achieved to address the U.S.'s structural problems. The Fed will come under more pressure to stimulate the economy. As long as inflation remains low in the short term, the Fed has the excuse to stimulate more, even though it's really driven to do so under political pressure.
 
The Fed will soon announce a scaling up of QE 2. The market estimates the range to be between US$ 500 to 1,500 billion. The dollar is expected to be highly volatile up to the Fed's announcement. If the announced figure is over US$ 1 trillion, the dollar is likely to depreciate, and vice versa. While the currency volatility may decline somewhat after the announcement, it will return when the Fed signals more stimulus, because the monetary stimulus won't solve the structural problems.
 
Since the crisis began two years ago, the Fed has expanded its balance sheet by US$ 1.7 trillion to US$ 2.6 trillion. It will likely continue to expand until either inflation comes to check its policy freedom or the economy recovers sufficiently. The latter depends on when unemployment begins to decline significantly, which requires the economy to grow significantly above 4 percent. The odds are that inflation, rather than growth, will cause the Fed to change its policy. That is one year away. The world must be prepared for currency volatility before then.
 
The Fed's QE affects the currency market rather than the U.S.'s domestic demand – its intended target. Domestic demand is composed of consumption, investment, and fiscal balance. The U.S. household sector is over-leveraged and is coping with asset deflation. Its net asset declined to US$ 53.5 trillion in the second quarter of 2010 from US$ 64.1 trillion in 2006. And its debt declined to US$ 13.45 trillion in the second quarter from the peak of US$ 13.92 trillion. The wealth reduction is 18 times the debt reduction. It is hard to see how extra liquidity due to QE will prompt the household sector to borrow and spend. It becomes possible if the household sector believes in high inflation and low interest rates for years ahead, which means a lower debt burden in future. Hence, they may borrow more now. But, high inflation expectations will prompt everyone to sell treasuries. The collapse of the treasury market will bring down the economy. Thus, the Fed cannot create high inflation expectations now. QE is unlikely to cause households to leverage up.
 
The U.S.' big corporate sector, i.e., listed companies, has US$ 2 trillion in cash on hand or 6 percent of its total assets, a two-decade high. Lack of liquidity seems to be their last worry. They are using the cash for buying other companies or share buybacks. How they allocate their cash clearly exhibits a low desire for investment. On the other hand, they are showing quite a lot of enthusiasm for investment in emerging economies. There are many reasons to explain their behavior. They point to the structural problems that central governments can help solve. But, they may simply take time to resolve. The Fed's QE doesn't address their concerns.