Foreign Exchange Reserves in the Context of Interest Rate Increases
By JC Collins
“Our interest in strengthening the Fund is not based on esoteric notions of global leadership or nostalgia for institutions that the United States created. Rather, we have learned from hard-won experience that a well-resourced and effective IMF is indispensable to achieving our economic and national security interests.”
This was a statement made a few days ago by US Treasury Under-Secretary for international affairs Nathan Sheets when giving an official statement surrounding the US Congress’s failure to meet the September 15th deadline on the 2010 Quota and Governance Reforms.
Sheets also explained that “To ensure the IMF remains at the center of the multilateral economic system – and that we maintain an important voice in it – the United States should promptly approve the 2010 quota and governance reforms.”
The joint statement from both the Treasury and the International Monetary Fund has presented a unified front in regards to the reforms of the executive board and quota amounts. Gerry Rice of the IMF said that they would discuss options on interim steps before the end of the month.
This fits with the schedule originally laid out by Managing Director Christine Lagarde last month where she stated that the reform deadline would be set for Sept 15th and interim options would be decided by Sept 30th. This would be followed with the implementation of those options by December 15th.
Whether the US Congress quickly passes the supporting legislation on these reforms or not, the clock is ticking, and it looks like further delays will not be allowed.
Interim options could include ad hoc increases to the quota amounts for the emerging economies. This would in effect bypass the Congress and decrease the pressure on that Congress associated with the 2010 Reforms.
There are some interesting dynamics playing out right now in the world of monetary policy and reform. On the one hand we have the Quota and Governance Reforms which have been delayed and delayed since being agreed upon back in 2010. The reforms themselves were born from the financial crisis of 2007 and 2008.
The other dynamic surrounds the normalization of monetary policy by the Fed and other central banks around the world. The return to increasing interest rates will have to happen at some point. Many contest that there will have to be a reset of the system before interest rates can increase again.
Others contest that an increase in interest rates will in effect kick-off the reset which needs to take place.
The other name for a financial reset is the transition from a unipolar dollar based framework to a multilateral multi-currency framework which we discuss and review in detail here on POM.
Last week when the Fed failed to increase interest rates again it surprised just as many as it didn’t surprise. But an interesting thing happened. Before the Fed announcement it was widely considered impossible for the Fed to raise rates again. It was stated that the ensuing volatility after the increase would tank markets and spread world-wide deflation further and contract growth tighter.
Now, almost a week after the announcement of no rate increase, the markets have responded in the negative as it is being widely considered that the Fed will never raise rates. The momentum and demand for the Fed to raise is increasing and what once would have caused market volatility is now being considered the one thing that may in fact calm markets and bring a sense of normalcy back to the financial and monetary world.
When we consider this normalization of policy along the same lines as the 2010 reforms, we begin to see a pattern of US accommodation in regards to the multilateral framework which can shift responsibility and causation back onto the international institutions and central banks themselves.
The Treasury calling for action on the reforms, and the growing demand for the Fed to act on interest rate increases could very well be the play which will slowly reveal itself in the coming months. The only missing piece is the response from the emerging economies on any Fed rate increase.
In the last post titled Potential Path Forward on Fed Rate Increases – Sovereign Wealth Funds, Reserve Diversification, and Capital Flows, we reviewed the possibility of central banks transferring their USD denominated foreign exchange reserves into sovereign wealth funds and investing those funds into the equity markets.
This reduction in USD denominated reserves by the central banks of the emerging economies will reduce their exposure to any Fed rate increases and responsive depreciation of the USD as global demand for the currency decreases.
How all of these components play out is challenging to predict, as last week’s interest rate increase stay can attest. But what is clear is that there is a larger pattern beginning to emerge. The 2010 reforms were the beginning of this pattern, as were low interest rates. The correlation of both trending towards a multilateral framework which takes into consideration the well-being of all economies, both developed and emerging, is extremely suggestive of financial and monetary changes on the horizon.
We will have to wait and see how the US Congress responds to the ad hoc interim options, and how much longer it takes for monetary policy to begin the process of normalization. In the meantime, watch for additional changes in the foreign exchange reserves, as that is where the rubber meets the road. – JC