Is the Dollar Getting Too Strong?

October 20, 2008

If the U.S. recession were not associated with dysfunctional credit markets and if other economies were not also in recession, the dollar would be falling and providing needed support for net exports by enhancing the competitiveness of U.S. exports in foreign markets and of domestically produced goods that face imported competition.  Economists call such mechanisms automatic stabilizers because, without proactive policy adjustments, they mitigate a recession’s severity.  In this global recession, where markets are being moved by the primacy of investment safety and forced asset liquidations, the dollar is instead appreciating significantly. 

  • At today’s highs, the dollar was stronger than its third-quarter lows by 39.7% against the Australian dollar, 24.0% against the New Zealand kiwi, 20.7% against the euro, 20.1% against the Canadian dollar, 17.8% against sterling, 15.1% against the Swiss franc, and even 9.2% against the Japanese yen, which has benefited too from the capital flow environment.
  • From year-ago levels, the dollar is up by 26.4% against the Australian dollar, 24.2% against the Canadian dollar, 19.5% each against the kiwi and sterling, 12.3% against the yen, and 7.1% against the euro. It remains 1.5% lower against the Swiss franc in such terms.
  • The dollar has advanced sharply against a variety of emerging-market currencies like the Mexican peso, Brazilian real, and Korean won.
  • The trade-weighted dollar rose another full percent today and has climbed 15.3% above its third-quarter low.

The U.S. economy is more trade-reliant than it used to be.  In the latest reported quarter, exports and imports comprised 13.5% and 18.5% of nominal GDP.  The old rule of thumb that it takes a 10% trade-weighted dollar advance to produce the same economic drag as a 100-basis point rise in short-term interest rates is probably is too high. With those kind of trade/GDP ratios, a 15% rise in the dollar might more likely pack the power of a rate increase closer to 200 basis points than 150 basis points.  In either case, the 50-basis point Fed funds rate cut on October 8th, the first cut since a 25-bp move implemented at end-April, didn’t restore monetary conditions to end-1Q08 levels. More stimulus is needed for that, and the Fed will comply.

From a long-term perspective, however, the dollar remains depressed.  It is still slightly more than 30% below in trade-weighted terms than its average level in the first quarter of 2002.  In the long term, moreover, it will be good to let this episode of a climbing dollar run further.  If investors come to see the dollar as a chronically weakening currency, the sense of two-way risk will fade and could jeopardize the dollar’s position as the most-favored reserve currency. Euroland in particular will benefit from a more expensive dollar, and so will other economies in Europe and Africa that tie their currency to the euro. I do not see any G-7 authorities stepping in soon to stop the dollar from climbing further, but appreciation will give the Fed more flexibility to keep cutting its benchmark interest rates and counter any exchange rate-induced drag in that way.

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