Only the Fed can crash Wall Street

Wall Street
Brendan McDermid | Reuters

Here is why: Through its direct and indirect control of American interest rates, the Fed exercises a decisive influence on dollar-denominated asset valuation models.

With that in mind, how can anyone think that peripheral foreign exchange moves and flagging East Asian growth dynamics could throw the Big Board into an irretrievable decline?

The Fed also controls a currency that remains an indisputable unit of account, means of payment, and store of value for the world economy. No other wannabes come even close to the greenback's "moneyness" characteristics. And, the Fed willing, the dollar can easily retain its key currency status for a long, long time to come.

The Fed's alleged "benign neglect" of the dollar is a myth, because the dollar's relative price is one of the main variables determining trading conditions in one-third of the U.S. economy. But since the dollar is the anchor of the global financial system, the U.S. cannot actively orient its value to suit its foreign trade objectives, as is the case of export-driven developing economies. No, the Fed indirectly influences the dollar's exchange rate by adjusting the quantity of money to execute its mandate of full employment and price stability.

The U.S. is the growth engine

Acting alone against a strong fiscal drag, the Fed has done a good job on both counts. Over the last four quarters, the U.S. economy has grown at an average annual rate of 2.8 percent, an entire percentage point above its potential, delineated by the noninflationary utilization rate of (physical) capital and labor resources.

Predictably, that has spurred the demand for labor, bringing down the unemployment rate since the middle of last year from 6.1 percent to 5.3 percent, while the core rate of inflation (the headline rate minus food and energy) remained stable at about 1.8 percent.

Now, here is something for those lamenting that the world's stalling "growth engines" in Asia and Europe have led to recent equity market problems. These "growth engines" are, in fact, a huge drag on world economy. They are living off the rest of the world. Or, in Donald Trump's colorful New York vernacular, "they are eating our lunch."

Here are some numbers. East Asian countries (including Japan) sold last year $492 billion of goods and services more than they bought from their trade partners. The euro area did the same; its trade surplus (two-thirds of which went to Germany) was a close second at $445 billion. This year, East Asian and euro are trade surpluses are expected to hit $650 billion and $450 billion, respectively.

That is a cool $1.1 trillion these "growth engines" will be making off the slowing world economy.

In the middle of all that, the U.S. remains a net contributor to global economic growth. Last year, America bought $411 billion more of goods and services than it sold to the rest of the world. This year, that number is expected to reach nearly $1 trillion – as the sputtering, export-driven East Asian and European "growth engines" continue to take advantage of a nicely growing, Fed-fired American economy.

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But the free-loaders better be careful. The U.S. is entering an election year. That is the time when the economy takes center stage until ballots are cast in the first week of November 2016. The export "growth engine" countries should not be lulled into believing that trade issues will be ignored just because Donald Trump is the only presidential contender talking about them. Regardless of how far he will go in the election process, Trump is connecting on trade problems with both the general public and some corporate big guns, who appear to be quite sympathetic to what is currently known of his political platform.

The Fed needs no advice

Meanwhile, the Fed is getting a large amount of unsolicited advice from foreign official and private observers to keep its policy unchanged. Some of that advice is so pedagogically patronizing – e.g., "it would be a mistake to raise interest rates amid market turmoil" – that I am reminded of a visibly irritated Mario Draghi, President of the European Central Bank, "thanking" the IMF, tongue-in-cheek, for being so "generous with its advice."

Obviously, the Fed's foreign cheer-leaders don't want to see anything interfering with their booming exports to the U.S. That is easier than reforming their economies to generate more growth from their domestic demand, and to achieve a more balanced and sustainable organization of their economic activity.

But that may change faster than most people think. Germany, for example, is under increasing pressure from its euro area partners to stimulate its domestic demand, lest the monetary union perish under an unbearable burden of uncoordinated (some in Europe call it "selfish") economic policies. In the first quarter of this year, Germany's trade surplus with the euro area was running at an annual rate of 71 billion euros, a whopping 14 percent increase from the year before. In spite of that, Berlin keeps complaining about the policies of its euro partners, scaring the Germans about the 86 billion euros debt package for Greece, of which Athens won't see a cent because the money will go right back into the coffers of German and other lenders.

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It is perhaps even more urgent for East Asia to wean itself off the export gravy train and generate more growth from its domestic demand. But don't hold your breath for that; East Asia's anguish at the prospect of Fed's long-overdue interest rate normalization is not a good sign.

Japan, for instance, is not only asking the Fed to stay put; its economic policy makers are also announcing another round of aggressive monetary easing which, like the previous ones, will do virtually nothing for domestic demand. As before, these new waves of yen's excess liquidity will push the exchange rate down to seek salvation via exports. And that policy is working. In the first half of this year, the merchandise trade deficit has been halved. During the same period, Japan's current account surplus has soared fourfold to $97.1 billion, and is well on the way to exceed $120 billion by the end of this year -- a stunning increase from a $22.9 billion (sic) surplus in 2014.

Investment thoughts

The U.S. equity markets are not threatened by insignificant foreign exchange rate changes and East Asia's slowing economies.

Reserve movements in the first half of August and interbank trading conditions are not showing any clear departures from the Fed's current policy stance. If any such move is contemplated in the near future, the Fed would probably telegraph its intent well in advance so that the actual policy change would be a largely discounted non-event.

The European Central Bank will continue its supportive policies, and China's monetary authorities will do the same. I also hope that China will put a bit more fiscal stimulus in its policy mix.

Improving growth fundamentals and easy monetary policies bode well for U.S. equity markets. A note of caution, though: At this stage of the business and policy cycle, liquidity driven valuations will be under constant review to re-price assets in accordance with firms' expected operating results.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.