Editorial comment: Dollar puzzle
Published: March 21 2001 19:43GMT | Last Updated: March 22 2001 04:02GMT
The recent performance of the dollar against the euro is, to put it mildly, puzzling. The US economy is flirting with recession and US interest rates are down 1.5 percentage points. So why has the dollar been so strong? Since the start of the year, the euro's value has fallen back below $0.90 from $0.95: the dollar is at a 15-year high on a trade-weighted basis.
Well-rehearsed reasons for past dollar strength against the euro no longer apply. First, relatively poor economic growth in Europe can no longer be blamed. Published growth rates and economic forecasts have fallen by more in the US than in the euro-zone. Second, US interest rates have declined relative to those in the euro-zone, both at the short and long end.
Foreign exchange markets find daily excuses to push the euro lower against the dollar. On Wednesday, a weak German IFO index was the culprit: the business climate index for western Germany fell to its lowest level for 18 months. But these explanations do not stand up to inspection.
For example, German business confidence may be falling but that does not imply a German, let alone a European recession. Germany represents only a third of euro-zone output and the IFO index is a poor indicator. Since 1961 it has fallen by a similar or greater amount 11 times, more than twice as often as output has fallen.
Various other explanations for the dollar's strength have been doing the rounds. Perhaps the currency markets expect a short US downturn, and are already looking towards the green fields beyond. Maybe US and Japanese investors have been selling their European equities first. Perhaps investors still see the US as a safe haven in turbulent times. Theoretically, the currency markets might expect large US tax cuts to push up real interest rates as they did in the early Reagan years. None of these explanations holds water, particularly as they are not consistent with moves in other financial markets.
For Europe, a weak currency is not much of a concern. It helps exports and should not seriously affect thinking at the European Central Bank. For America, a strong dollar is more problematic. It means the US will find it harder to mitigate its downturn through higher exports. But policymakers cannot call for a gradual dollar decline for fear that things might get out of hand.
So the strength of the dollar seems to defy explanation. But so - until recently - did the enduring strength of equity markets. There must be a chance that soon, with some trigger, the dollar will fall from grace.
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