A Good Year for the Dollar… But Maybe Too Much So

November 23, 2015

It’s easy to be lulled into viewing the dollar as rising only moderately.  Eight months have passed since its 2015 high against the euro was touched, and common European currency and yen each show little net change since then against the dollar.  A comparison of dollar changes over the last twelve months presents a much more impressive dollar profile.  The U.S. has appreciated 39% or more against the currencies of Brazil, Russia and Colombia.  It has advanced at least 29% as well against the monies of South Africa, Turkey, Norway and Malaysia and over 14% versus the currencies of Chile, Denmark, Sweden, Poland, Canada and Euroland.  Additional gains of at least 5% took place against the South Korean won, Indian rupee, Argentine peos, Japanese yen and Swiss franc.  The government-controlled Chinese yuan and the British pound lost slightly less than 5% against the greenback.

Three important developments have transpired over the past month.  First, commodity price deflation has resumed, which has implications for overall inflation, future changes in monetary policy, and business investment in alternative energy sources.  Second, notwithstanding the further decline in commodity prices, the possibilities of a Federal Reserve interest rate hike and an ECB rate cut next month have become more likely.  When the Fed started the last U.S. rate normalization cycle in June 2004, an ECB rate hike followed five months later, and when the Fed commenced a previous rate cycle in June 1999, the ECB again followed suit a few months later.  It’s been over two decades since rate trends in the U.S. and Europe diverged, and directionally opposite central bank actions in the same month — no less December — is a rare juxtaposition indeed.  The third notable development has been the escalation of ISIS terrorism outside of Syria and Iraq.  It’s probably not accidental that this is happening just a holiday-season away from the start of U.S. presidential primaries.  The intent is to create general chaos, and what better way to do this than to influence politics in Europe and the United States.

Global price trends remain highly disinflationary, and in such an environment, an appreciating dollar causes more harm than benefit by accentuating excessively low U.S. inflation, making both U.S. exports and import-competing goods less competitive, and raising the debt service burden of emerging economies holding dollar-denominated debt.  The influence of a rising dollar on prices and economic activity is not felt right away, so much of the aforementioned currency swings over the past twelve months is yet to be felt.  The firm dollar will flatten but not prevent the tightening path of the Fed, lending an upside bias to longer-term U.S. interest rates. 

The U.S. economy looks shiny only through a relative prism.  It has expanded faster than the eurozone’s and even more so against Japan, where real GDP contracted in both inside quarters of 2015.  That growth advantage is projected widely to persist in 2016-17, but the U.S. will nonetheless remain sub-par by U.S. own historical standards as attested by the 3Q preliminary measurements of GDP, which rose 1.5% annualized from 2Q and 2.0% compared to the year-earlier quarter.  Three widely-discussed U.S. economic problems are a diminishing middle class, slowly rising labor productivity, and an historically depressed labor participation rate since the Great Recession.  Studies show that widely dispersed income and wealth has a dampening effect on overall economic growth.  Labor productivity has slowed from 3.2% in the first five years of this century to 1.9% per annum in the next five-year period and only 0.5% over the latest five years.  America’s labor participation of 62.4% in October was down from 63.0% a year earlier and way below levels before the financial crisis.  While many other OECD economies have much higher jobless rates than the U.S., a big reason for this is that their labor forces did not experience the kind of permanent haircut as in the United States.

In light of the above structural shortfalls and the proliferation of bad ideas emerging in the early going of the presidential campaign, the U.S. economy is vulnerable to additional shocks such as a fresh upward thrust of the dollar.  Monetary normalization will be achieved through a combination of higher U.S. interest rates and dollar appreciation.  It will be healthier if that mix is skewed toward a rise in interest rates rather than through a significant additional rise of the dollar.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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