BNY MellonJackson Hole Conference Productivity FocusFederal Reserve Chairman Powell’s breakfast speech this morning in Wyoming will be focusing on the main topic of the Kansas City Fed’s Jackson Hole Economic Symposium: “Reassessing Constraints on the Economy and Policy”. Unleashing productivity growth will, in our opinion, take the driving seat in FX markets for years to come.In a world where inflation converged across the globe, FX market participants increasingly focused on current account imbalances and capital flows. Countries delivering faster domestic demand would, in turn, develop large external imbalances, which required capital inflows to balance external accounts. In this note we denote such currency valuation models Balanced Equilibrium Exchange Rates (BEER).While this backdrop remains the case, large inflation differentials will likely bring currency markets’ attention back to price dynamics and productivity. The idea that exchange rates adjust to make up for price differentials is quite intuitive. This is the backbone of the so-called Purchasing Power Parity currency valuation models (PPP).Nevertheless, price differentials may prevail for a while, warranting an additional factor to explain currency strength. Enter productivity growth. Countries able to produce the same quality goods and services more efficiently than others would therefore be able to sustain stronger exchange rates and/or higher inflation. As a result, an additional modeling framework helps explain FX valuation with factors such as terms of trade (ratio of export to import prices), foreign direct investment and labor productivity. We define such a framework Dynamic Equilibrium Exchange Rate (DEER). Countries in which productivity growth is collapsing will therefore need to deal with an expensive exchange rate, and perhaps also the risk of currency crisis down the road.In the chart below we calculate two simple BEER and DEER models for the USD. We define BEER misalignment as the real effective exchange rate adjustment required to close the external gap in the US’s balance of payments. On the eve of the Great Financial Crisis, the USD’s BEER was overvalued by as much as 20%. According to this model, the USD is now 12.9% overvalued, as the current account deficit has been widening substantially since June 2018, from 1.8% of GDP to 3.9% of GDP now.The dark line represents a DEER valuation model that incorporates terms of trade, foreign direct investment, and labor productivity in the US. DEER misalignment is therefore the currency adjustment required to close the gap opened from excessive or lagging productivity growth. These factors explained a cheap USD in the 1990s and a subsequently expensive USD following the NASDAQ collapse and a dearth of business sector investment thereafter. The shaded area is the USD real effective exchange rate, which accounts for inflation differentials and trade-weighted exchange rates.