What's in Store for the Dollar?
By John H. Makin
In a growing global economy, everyone likes a strong currency. It implies that a country runs at the head of the growth pack, and it helps keep inflation at bay. During the 1990s, the United States was such a country.
In a shrinking global economy, everyone wants a weak currency, though no one says so. Each country needs a bigger piece of a shrinking pie, and a weaker currency helps to boost lagging demand at home. Awkwardly for other countries, it makes foreign goods more expensive and, thus, domestic goods more attractive. With excess capacity and a weaker currency, inflation is not really an issue. Most of the countries involved in the Asian debt crisis found themselves in these circumstances by mid-1997 and subsequently devalued. Japan, in fact, is still an economy with considerable excess capacity and is counting on help from a weaker yen and a U.S. recovery to boost exports.
A Weaker Dollar?
A new factor has emerged in the global currency markets this spring. A confluence of market events is suggesting that the U.S. economy may need a weaker dollar to drive a sustainable recovery. Since early this year, and mostly during April and May, the U.S. dollar has fallen by about 5 percent in value, while the stock market has weakened and interest rates have gone down by 30 to 40 basis points. Meanwhile, a jump in the April unemployment rate to 6 percent, the highest level since 1994, underscored corporate and market expectations of a weakening economy and weakening profits.
It will be very interesting to observe the response in the global economy should the recent drop in the dollar accelerate. American manufacturers and labor unions are screaming for a weaker dollar while the U.S. Treasury speaks uneasily about a strong dollar being in the nation's best interests. It may be in America's best interests when the world economy is strong, but it may not be in the best interests of the United States when domestic demand growth is insufficient to propel a sustainable recovery that includes a rise in capital formation.
In this period of queasiness about the dollar, a Plaza-style dollar depreciation proposed to Treasury Secretary Paul O'Neill by Sen. Paul Sarbanes (D-Md.) entails a lot of wishful thinking. The Plaza Accord of September 8, 1985, aimed at pushing down the dollar and came at a time when the Japanese economy was strong and Germany was essentially run by the hard currency Bundesbank. But now with the dollar down from 135 to 127 yen, Japanese policymakers are already murmuring nervously, and a little foolishly, about the absence of a "need" for a stronger yen. Indeed, in deflationary Japan, a stronger yen would be an unmitigated disaster, and most Japanese policymakers know it. Meanwhile, the Swiss National Bank has protested the run out of dollars into its safe-haven currency by cutting interest rates by 50 basis points on May 2 after markets, unnerved by Secretary O'Neill's squabble with the members of Congress over the strong dollar policy, pushed the dollar to its lowest levels since just before the September 11 terrorist attacks.
Take a look at the fundamentals. The U.S. current account deficit means that about 1.3 billion dollars are on offer in the foreign exchange markets every day. As the desire of international investors to acquire more assets in the United States begins to cool, the capital inflows that snap up those available dollars has started to slip and so has the dollar.
The important point is that if the United States needs a weaker dollar to sustain its recovery, most of the rest of the world's countries need lower interest rates to sustain theirs. This requirement leaves Japan out in the cold, unless the Bank of Japan finally gets busy and starts pumping out liquidity at three or four times the current rate, as was required to end Japan's deflation in the 1930s. There is plenty of room for further interest rate cuts in Europe and Canada. In the latter, a macho central bank recently pushed up rates by 25 basis points as part of a premature show of confidence in Canada's economic recovery, which is tied closely to U.S. prospects. To quell a strengthening currency, America's other major hemispheric trading partner, Mexico, in April reversed a 60-basis-point rate increase that had been enacted in January.
A Dilemma for the Fed
A weaker dollar could present the Federal Reserve with a conflict between the needs of the domestic economy for continued monetary accommodation and the need for tighter money to achieve external balance and slow the dollar's decline. After all, with an eye on the domestic economy, the Fed has cut interest rates by 475 basis points since January 2001, only to see the U.S. stock market subsequently drop last year for a second year in a row and to watch stocks weaken again this year as concerns about sustainable growth and profits keep stock prices under pressure.
The other part of the Fed's dilemma is tied to the extraordinarily low current level of short-term interest rates. Such low short-term interest rates have encouraged households to continue to purchase consumer durables, housing, and related items at a vigorous pace, especially viewed in the context of the weak employment picture. Meanwhile, corporations have increased issuance of long-term debt but have converted their borrowing into short-term debt because of the extraordinarily low rates on offer, thanks to the Fed's very accommodative stance on the Federal funds rate.
The heavy dependence of households and corporations on low short-term interest rates puts the Fed in a delicate position. On the one hand, it may make sense to wait until it sees signs of a sustainable recovery to tighten, because once it tightens, the effective costs of borrowing for households and corporations will jump sharply and the strong housing and consumer durables sectors will weaken quickly, while the corporate profit picture will deteriorate as corporate borrowing costs jump. On the other hand, the Fed's ability to slow the economy, given the current heavy dependence on short-term borrowing, is almost too great-making the Fed reluctant to raise short-term interest rates.
So far, no warning lights have flashed to suggest that the Fed has been too easy for too long, thereby risking higher inflation. The combination of a weaker dollar, lower interest rates, and lower stock prices unambiguously suggests an expectation of slower growth. If the weaker dollar were signaling an expectation of higher inflation, it would be accompanied by higher interest rates and would then provide an unmistakable sign of a serious conflict pitting the Fed's desire to accommodate the domestic economy against the need to maintain external balance to avoid a sharp, inflationary drop in the dollar.
Markets Jittery
In the face of renewed uncertainty about the sustainability of the U.S. recovery and implications for the dollar, interest rates, and stock prices, markets have turned more volatile this spring. The Fed cannot be happy to see that its accommodative monetary policy stance is largely boosting spending on housing, automobiles, and related items instead of causing investment spending to resume. The Fed is getting some of its wished-for "demand growth," but it is coming from retail sales and housing, not from the more respectable kind of demand growth, investment spending, which also boosts capacity and so is not inflationary. But the faster growth of consumption spending, in contrast to a jump in investment, is not unambiguously good for the dollar, especially if any hints of inflation should appear.
The most benign case would be that the weaker dollar is indicating that more stimulus is needed to sustain demand growth at a level sufficient to induce the capital spending and additions to capacity that have been identified as necessary conditions for a sustainable U.S. recovery. The weaker dollar, by exporting some deflationary pressure from the United States, then would serve as a forcing mechanism that creates pressure for lower interest rates in countries that have become overreliant on the U.S. demand growth locomotive.
Rx: Lower Tax Rates Instead of Higher Spending
Even if the dollar does weaken for a time, the Treasury and Congress can take steps to create higher growth and a firmer dollar. Lower tax rates would enhance both demand and supply growth in the U.S. economy, while pushing up expected real rates of return on investment and thereby helping to strengthen the dollar. Another $100 billion in tax cuts that could push next year's deficit to $150 billion instead of $50 billion would be far better than another $100 billion in wasteful spending on agricultural subsidies. Additional deficits created in the short-run by lower tax rates that promise higher growth are not a problem for global capital markets to absorb, since subsequent higher growth would erase future deficits.
Meanwhile, the Bush administration would do well to abandon the idea of a "dollar policy." The exchange rate is a price determined in global currency markets. Having a dollar policy that includes strong-dollar rhetoric suggests a willingness to intervene in currency markets should the dollar become "weak." That is not the stated policy of the Bush administration, so probably the less said about the "dollar policy" the better. |
