Dollar in Rare Limelight

October 7, 2015

The value of the dollar dominates U.S. economic policy so rarely that the exceptions still out boldly and counted on the fingers of a single hand.  Other countries don’t have that luxury.  America’s exceptionalism in this regard since the Second World War springs from the U.S. currency’s unchallenged dominance as a reserve currency.  Typifying this distinction, former U.S. Treasury Secretary John Connally in November 1971 told his European colleagues that “the dollar is our currency but it’s your problem.” 

Here are the few exceptions.  On November 1, 1978, a package of policy initiatives to halt a sinking dollar was announced from the White House, including an unprecedented one percentage point hike in the Federal Reserve discount rate.  That moment reflected the belated realization that relentless dollar weakness and accelerating domestic inflation reflected different elements of the same mutually reinforcing problem and that a successful effort to cap and reduce excessive inflation would not happen if dollar-supporting measures were not included.  By 1985, the dollar had become too strong for the good of the U.S. economy, and it was driving an unhealthy wedge between the U.S. current account and those of its allies.  The dollar had peaked early that year, but western finance ministers including U.S. Treasury Secretary James Baker in September announced the Plaza Accord that formerly set a goal of broad dollar depreciation promoted by macroeconomic policies explicitly customized to promote that objective.  In the mid-1990s, Treasury Secretary Robert Rubin popularized the mantra that a strong dollar is in the best interest of the United States, thinking that such would promote low inflation, capital inflows, and inexpensive long-term interest rates.  Aside from the 1978 example, Federal Reserve monetary policy was not directly by either the level or movement in the dollar. 

Fed policy may be entering another such moment.  The decision not to raise the federal funds target at last month’s meeting was influenced by the dollar’s strength, which helped depress import prices by 11.4% in the year to August versus only a 0.3% dip during the previous 12 months.  U.S. inflation has stayed persistently below expectations and the Fed’s target in part because of falling prices for imports and dampening effect on import-competing goods.  Fed policymakers aren’t targeting the dollar but must take account of its movement to the extent that expectations of U.S. inflation are impacted.  Perceptions of U.S. growth are also influenced, as the strengthening dollar weakens net foreign demand.  U.S. real consumer spending growth remained robust in the summer, but forecasts of quarterly GDP growth have been been trimmed to nearer 2% than 3% because of deteriorating foreign demand.  Weaker growth implies a slower decline of unutilized productive resources and a shallower and more prolonged ascent of inflation toward the goal of 2%.  This would allow the Fed to normalize short-term interest rates more gradually, and that’s why monetary officials have been telling the market that the timing of the first hike is less important than what follows.

This website focuses on the currency relationships that are most widely traded like dollar/yen, cable, EUR/USD, Swissie and a trio of commodity-sensitive monies of Australia, Canada and New Zealand.  However, monetary officials are watching a broader basket of currencies.  The euro has in fact stabilized, averaging $1.116 in May, $1.123 in June, $1.101 in July, $1.114 in August, $1.123 in September and hovering around $1.125 earlier today.  Dollar/yen has likewise found a comfort zone near 120.  But Fed policy hasn’t put the dollar back in the closet, since many emerging market currencies are continuing to depreciate, thus enhancing the dollar’s broad trade-weighted value.

A more important issue concerns the the dollar’s future hegemony as the world’s favored and widest used reserve currency.  From time to time, predictions emerge of a coming transition to a different international monetary order, and each time until now those musings have been put to rest by strong counter-arguments that such an event lies decades away.  Another flurry of articles recently on the dollar’s role at the center of the system seems more serious than earlier challenges.  The latest issue of The Economist devotes a 14-page special section to the topic, noting the erosion of several properties that generally legitimize what constitutes a dominant reserve currency.  The likeliest scenario still sees the dollar’s role changing exceedingly slowly, and being a reserve currency up to now has never been a basis for chronic strength against other major monies like the yen, Swissie or euro.  Still, a more public reexamination of the world monetary system is not a dollar positive.  The replacement of the previous reserve asset hegemon, sterling, by the dollar was associated with a considerable loss of the pound’s value against other world monies.

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



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