Long-Term Trend of the Dollar

January 5, 2009

In the 36 years between end-1972 and end-2008, the dollar depreciated 3-1/3% per annum against the Japanese yen and 2-1/4% against the D-mark.  Over the 26 years prior to the launch of the euro (which fused the mark to other continental currencies), the dollar fell 2.5% per annum on balance against Germany’s currency. Among the last ten years, the dollar posted an end-year to end-year gain against the euro five times including in 2008 and also dropped in five calendar years.  On balance, it fell 1-3/4% per annum, a slower pace of erosion than between end-1972 and end-1998.  Dollar/yen also fell more slowly in the last ten years, 2.2% per annum, than during the previous 26 years (3.8% per annum).  However, the yen rose 22.9% last year.

It’s not surprising that the mark advanced somewhat more sharply against the dollar when it was Europe’s anchor currency than the pace of advance of the euro over the last decade.  The earlier period includes some years of double-digit U.S. inflation and encompasses the initial years of floating dollar rates, when the dollar fell very rapidly after having been artificially fixed by officials at increasingly uncompetitive levels. Also, Deutsche mark strength in the earlier period reflected demand out of inherently weaker other European currencies as well as out of the dollar. One reason for creating a common European currency was to end opportunities for regional currency speculation.

Dollar/yen’s rate of depreciation slowed more sharply after 1998 than the average drop of the dollar against Europe’s main currency.  This deceleration does not seem to be related to weaker Japanese growth, since Japan suffered a stochastic drop in actual and potential growth in the early 1990’s and thus well before 1999.  It’s more plausible that upward pressure on the yen was tempered by Chinese foreign exchange policy, which froze the yuan against the dollar until 2005 and limited appreciation thereafter.  Prior to April 2004, moreover, Japan’s Ministry of Finance had engaged in very heavy intervention to cap the rising yen.  Quantitative monetary easing for five years to early 2006 by the Bank of Japan also constrained the yen’s scope for rise.

The dollar has a well-established long-term downtrend, which continued during the last ten years, albeit at a somewhat reduced intensity.  The continuing admission of new joiners of the European Monetary System poses the main threat to the euro’s long-term upward course.  In the unlikely event that the euro does not survive the world recession with all of its members on board, the strongest component parts should emerge with an upward long-term trend against the U.S. currency. The dollar share of international reserves remains disproportionately high compared to U.S. shares of world GDP and trade, and the euro’s reserve asset role will grow.  In purchasing power parity terms, the yen is meanwhile significantly undervalued, so a further corrective upswing of Japan’s currency will be a growing long-term possibility.  The bottom line is that a continuing dollar downtrend remains the likeliest future scenario.

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