China's Renminbi and Lagging U.S. Economy Put Federal Reserve in Tough Spot

NEW YORK (TheStreet) -- Officials at the Federal Reserve are between a rock and a hard place. The culprit? The strong United States dollar.

The difficulties of the Fed can be split into a short-term problem and a long-term problem. In the short run, a stronger dollar has stifled U.S. exports and weighs down on GDP, pushing the Fed to keep interest rates low as the economy continues to go sideways. In the long run, the Fed has to worry about the threat of China's renminbi becoming a world reserve currency. 

The Short-Term Problem: The Dollar, the Fed and the U.S. Economy

Although the value of the U.S. dollar has fallen from a highs hit on March 13, 2015, its price in foreign exchange markets has recovered somewhat and has seemingly stabilized. On March 13, 2015, the U.S. dollar index, published by the Wall Street Journal, had risen by more than 25% since March 13, 2014. The value of the U.S. dollar rose more than 27% against the Euro over the same period of time.

The value of the dollar fell after reaching these highs and on April 15, 2015, the US dollar index was off almost 7% and it dropped by 8% against the euro that day.

The dollar rally has resumed and many analysts are looking for the value of the U.S. dollar against the euro to rise close to parity, one dollar exchanged for one euro. Quite a change from the rate of exchange in very early 2014 when it took almost $1.40 to acquire one euro.

The downside: with the rising strength of the U.S. dollar, the rate of growth of the United States economy has slowed down, with U.S. exports falling noticeably and with U.S. imports rising.

Even if the value of the U.S. dollar were to decline over the next few months, the econometric models used by the Federal Reserve System seem to indicate that future economic growth will be further impacted by the rise in the value of the dollar that has already taken place.

Officials at the Federal Reserve are on the verge of raising short-term interest rates. The timing of this raise is being hotly debated, both within the Fed and without.

Stanley Fischer, vice chairman of the Board of Governors of the Federal Reserve, has attempted to put such a raise in perspective so that such a rise will not cause a major turn in financial market expectations. Fischer has argued that any increase or two that takes place in the near future is just a move from the Fed being "ultra-expansionary" to being "very expansionary."

The dilemma now being faced by the Fed is that slower economic growth, caused by the strength of the U.S. dollar, could result in the Federal Reserve postponing any rate increases in the rest of 2015, and maybe beyond.

It is true that the market strength of the U.S. dollar has resulted from the fact that the monetary policy of the Federal Reserve System is out-of-sync with the monetary policies of other central banks around the world. These other central banks have created monetary policies that are "ultra-expansionary" while the Fed is expected to be moving in the opposite direction.

The Long-Term Problem: China's Rise

Chinese leaders appear to be succeeding in getting their currency upgraded to reserve currency status, which will allow them to continue on the path of challenging the supremacy of the U.S. dollar in the global economy. Already, the renminbi is gaining more business in Asian trading and investment and the Chinese are moving to further enhance the use of their currency in world investment markets.

The International Monetary Fund has now recognized the Chinese currency as not being undervalued in foreign exchange markets. China's leaders seem to be very cognizant of the fact that if they are to challenge the United States dollar, they must assure that their currency will maintain its value over time so that users can trust the value of the renminbi. That is, the renminbi must be a "strong" currency in the future.

The United States dollar has not really had a challenger of this magnitude over the past seventy years. As a consequence, the economic policymakers have been able to pursue fiscal and monetary policies that have created a "weak" dollar up until the past year. Economists have estimated that over this seventy year period the value of the United States dollar has declined by anywhere from 40% to 60%.

Over the longer-run, the United States cannot continue to follow such fiscal and monetary policies without turning over the foreign currency market to the Chinese.

The pressure on the Federal Reserve, and the United States government, in the short-run is to continue to stimulate the economy as has been done since the end of World War II, and focus on putting people back to work in the jobs they have been trained for, the Keynesian solution. If this is not done, the political pressure to do so will become immense.

For the longer-run, however, the health of the United States economy and its position in the world needs to be supported by a strong dollar, one that will be highly competitive against the renminbi. But, this will put the pressure on the Federal Reserve and the United States government to reassess the way it conducts its economic policy and the way it looks after the employment of the U.S. workforce.

It is said that Chinese leaders consider their decisions in terms of the impacts they will have over decades whereas American leaders focus only upon the next elections, a two-year horizon at best. Maybe the American leaders are going to have to lengthen their perspectives.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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