The yuan-dollar exchange rate is likely to be stable, more stable than headlines about Chinese currency policy would suggest.

Bill Conerly based on Federal Reserve data. Dollar-yuan exchange rate

Foreign exchange rates are important to the many businesses that buy or sell products internationally. Even plain and simple American companies are quite likely to have a supply chain that includes some imported products, just as many garden-variety businesses have some overseas sales. China’s recent announcement that it will use a heavier hand in its influence on foreign exchange rates raises the question of just exactly where that government wants the exchange rate to go. But it is an example of confusing and misleading economics statements. Foreign exchange rate policy is terribly misunderstood, so before going into the forecast, we’ll look at what government exchange rate policy can and cannot do.

Policy makers, politicians, and journalists often think that a country can manipulate its own currency independently of other major policy actions. That is not the case. Let’s go through the steps involved in pushing down a country’s exchange rate. (The reverse works when the country wants to push up its exchange rate.)

Supply and demand says that to lower a price, such as the price of the yuan compared to the dollar, China should supply more yuan. The Chinese government can do that by printing more yuan (including what we might call virtual printing, which is creating additional bank balances denominated in yuan.) So they create more yuan, and use them to buy dollars. This increases the Chinese money supply, which tends to lower short term interest rates in China. In other words, China can successfully lower its exchange rate through expansionary monetary policy.

But what if China’s leaders do not want to pursue an expansionary monetary policy? What if they’re worried about inflation? Sometimes a country in this position will “sterilize” its exchange rate intervention. So it offsets the increase in the money supply that it made to lower its exchange rate by contractionary monetary policy. The typical way to do that is open market operations, in which the country sells bonds in exchange for privately held money. That money is taken out of circulation, as if it were burned (the opposite of printed). So here is the process for sterilized foreign exchange rate intervention: print more currency, which is then sold in the foreign exchange market. Then burn an equal amount of currency in circulation through the sale of bonds.

The problem is that such sterilized exchange rate intervention has no impact. With no change in interest rates or expected inflation, and no change in imports or exports, there’s no reason for the exchange rate to be any different than before this process began. So as a general rule, sterilized intervention does not change exchange rates. It may appear to for a day or two, and political leaders may think they are impacting exchange rates, but it is not happening. (An exception is when there are a strict controls on flows of capital into or out of a country, but that is usually not the case.)

Here is what business leader should know about foreign exchange rate policy. Exchange rates move when monetary policy changes. If a country switches to a more expansionary monetary policy—faster growth of money and lower interest rates—then its exchange rate will decline relative to other currencies. If a country maintains its monetary policy, then no amount of  official policy intervention will impact exchange rates.

There are times when the country finds that it’s desired exchange rate policy aligns with its desired monetary policy. For example, in a recession a country usually wants a lower exchange rate to stimulate exports, as well as a lower interest rate to stimulate business and consumer spending. However, when the desired exchange rate policy conflicts with the desired monetary policy, then monetary policy will determine which way exchange rates go.

Now to the details of an exchange rate forecast. Current expectations are baked into today’s exchange rate. On the U.S. side, expectations are for two more interest rate hikes this year, with the possibility of a third. Then further interest rate increases in 2018. GDP will expand moderately. China has been increasing its interest rates as well, with special attention to deleveraging some of the riskiest sectors of the economy, such as real estate development. The mainstream view, reflected in the FocusEconomics Consensus Forecast East & South Asia. shows just a little deceleration of economic growth and a gentle rise in interest rates. This is consistent with official statements. If these expectations are met, both in the U.S. and in China, the dollar is likely to appreciate a bit because of more aggressive tightening in the U.S. than in China.

My own forecast for the U.S. economy shows slower growth than the Federal Reserve expects, which would slow their pace of monetary tightening. I have no differences with the mainstream view of China’s economic prospects. Putting the two economies’ forecasts side by side, there is not going to be a large change in the yuan-dollar exchange rate.