Trade-Weighted Dollar Up 9.3% in Less Than 8 Weeks

September 8, 2008

The Federal Reserve’s dollar index against other major floating currencies is 9.3% stronger than its low-point on July 15th.  This has been a powerful adjustment compressed into a very short time interval.  Such a rise extended for a full-year period would double the dollar’s value.  That is clearly not going to happen but underscores that the U.S. economy will not be boosted by quite as much monetary stimulus as most economic models had assumed.  A quick-and-dirty rule of thumb equates a 100-basis points change in short-term nominal interest rates to a trade-weighted change in the exchange rate amounting to the reciprocal of the share of GDP represented by the average of exports and imports in that economy.  In the U.S., trade flows comprise almost 15% now, which is about 1.5 times what it had been.  That implies that the dollar’s recovery since mid-July is likely to exert about the same impact as if the Fed had raised rates by a bit more than 1-1/4 percentage points.

This drag needs to be seen in at least four contexts.  First, the Fed sliced its rates by 325 basis points between September and April.  Second, the dollar had previously fallen extensively, such that today’s trade-weighted dollar level is still 1.5% weaker than its average in 2007, implying that the impact on monetary conditions of dollar movement from last year’s center of gravity to the present has still been a stimulus amounting to almost 25 basis points.  Third, changes in interest rates and in the dollar affect growth with long and variable lags, and the independent variables (interest rates and the dollar) are constantly on the move, thus always modifying the impact one might expect down the road.  Fourth, the credit crunch exerts its own drag on growth.  Much of the monetary stimulus merely neutralized part of that drag.  On balance, there has been a stimulus, which can be observed in the greater-than-expected and positive economic growth experienced in 1H08.  And indeed, the GDP data underscore the importance of the exchange rate component of that stimulus in the very high portion of growth attributed to net exports.  But since mid-July, that stimulus has been curtailed greatly.  Now, it’s possible the dollar could slide in the near term.  But it’s more probable that the U.S. currency instead will lengthen its rebound.  This spells possible trouble for 1H09.

When the Fed cuts interest rates, the stimulus helps U.S. export markets as well as the U.S. economy by strengthening U.S. demand for all goods, including imports.  When the dollar falls as it was doing in 2007 and 1Q08, the U.S. economy is stimulated, but other economies feel a drag because the dollar’s loss is a gain for their currencies, resulting in a potential loss of competitiveness.  When dollar movement swing from depreciation to appreciation as such did after March, the impact on relative economic growth between the United States and other economies is multiplied.  The U.S. feels a drag, and other economies get a lift.  This year’s surprise favoring U.S. relative to foreign growth could reverse direction in 2009 and do so rather abruptly.

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