Dollar and Relative Inflation

February 15, 2018

One theory of long-term exchange rate determination known as Purchasing Power Parity stipulates that currency movements have a tendency eventually to offset variations in relative inflation rates, such that the amount of currency A needed to purchase a bundle of trade-exposed goods in country A when converted into currency B will be just enough to buy the same collection of goods in country B at local prices. The theory implies that currencies countries experiencing relatively high inflation will over time depreciate relative to currencies in countries experiencing less inflation. Put differently, the internal price of money measured by domestic inflation and the external value of money measured by the exchange rate tend in time to converge. But there are limitations that separate theory from practice.

For one thing, PPP theory is expected to hold only in the very long term. It’s not a good strategic guide in the short horizon that currency traders operate. Second, not all goods are traded, and many services are not. The isolation of large parts of an economy from global market forces drives a wedge between the internal and external prices of money. Third, governments can magnify this isolation through the use of trade barriers, that is various commercial policies to protect local producers. Sometimes this takes the form of direct market purchases or sales of one’s own currency against others, known as currency intervention, or its soft cousin, which happens when government officials talk up or down their own currency by either threatening interference or by suggesting that a currency is too high or too low.

Currency movements are keenly influenced by investor expectations about what is going to happen. If relatively high inflation causes the financial community to anticipate tighter monetary policy to reverse that trend, a rise in inflation can actually lift a currency on the belief that interest rates will be raised in response. This is more likely to happen if a government and central bank enjoy the market’s confidence. That isn’t always the case, and the low regard with which the rest of the world holds the Trump administration suggests that credibility may way on the dollar in the current circumstance.

The United States already has higher inflation than Euroland or Japan. It’s latest on-year change in core CPI inflation, which excludes energy and food, is 1.8% compared to 1.0% in the euro area and 0.3% in Japan. Moreover, U.S. inflation after years of undershooting expectations is now accelerating. Total consumer prices over the latest six-month period reported (July 2017 through January 2018) rose at a 4.1% seasonally adjusted annualized rate (SAAR) versus just 0.2% SAAR in the previous six months. Even as this has occurred, Trump administration officials have been sloppy when talking about the dollar, seemingly trying to steer it lower to gain competitive advantage but without formally abandoning the 20-year-old strong dollar doctrine.

When governments treat their currency with neglect, a mutually reinforcing cycle of currency depreciation and higher domestic price inflation can take root. U.S. officials committed such a policy mistake in the 1970s. Too late to prevent very painful economic adjustment, U.S. officials came around to accepting this connection in November 1978, when a key element of a multi-pronged dollar rescue package was a full percentage point hike in the Federal Reserve’s operative interest rate.

U.S. imports now constitute 15% of GDP, a much greater ratio than it did 40 years ago or at the end of the 20th century for that matter. It takes less dollar depreciation these days to produce the same economic effect on the economy as a one percentage point hike in Fed interest rates than used to be the case. To wit, around a 6.5 percent drop in the trade-weighted dollar now is like a 10% move back in the day.

Comparisons of today’s dollar lows to the U.S. currency’s bilateral peaks since the beginning of 2016 show declines of 18.3% relative to sterling, 17.3% vis-a-vis the euro, 15.2% against the loonie, 14.4% versus the kiwi, 14.3% against the Aussie dollar, 12.3% vis-a-vis the yen, and 10.8% against the Swiss franc. One trade-weighted dollar measure compiled and reported on the Fed’s web site that measures movement against other widely traded major currencies shows a drop of 12.6% between late December 2016 and last Friday. The growth boost from such a slide is analogous to about a 175-basis point rise of the Fed funds rate. And since the nominal fed funds target has risen 125 basis points so far this cycle, it suggests that monetary conditions may actually be looser now than at the start of rate normalization. Such a finding seems to be supported intuitively by the considerable net appreciation of share prices even after the recent market correction.

The dollar, to be sure, does not take a one-to-one cue from changes in interest rates. The juxtaposition of dollar depreciation and rising fed interest rates is hardly unique. In the year from early February 1994 to February 1995, the Fed funds target doubled to 6%, yet the dollar weakened a bunch. In fact, exchange rates, asset values, and flows of capital are determined simultaneously by market forces. In this process, the marketplace can be far from but altruistic. It’s not the market’s responsibility to produce results that make the world economy function better. The market’s job is to find terms for prices and quantities exchanged to clear buyers and sellers.

While the current rankings of inflation and nominal GDP growth among the United States, euro area, and Japan clearly do not justify a weaker dollar. Nor does the U.S. current account deficit, which is at a manageable relative size by historical standards. If U.S. policymakers are perceived to be comfortable with recent dollar developments (and they are), if U.S. relative inflation is seen likely to remain somewhat elevated, and if “gradual” remains the most meaningful word in Fed rhetorical guidance about likely future policy, a reversal of the dollar’s directional risks does not appear very probable.

To take this update full circle, one final contrast with the late 1970s/early 1980s experience seems in order. The mix of a tight U.S. monetary policy and loose fiscal policy then is often cited as the reason that the dollar was so strong during the first term of Ronald Reagan’s presidency. Again we have monetary policy getting less accommodative, and the fiscal deficit ballooning. I submit that this is not a deja vu moment. The fundamental development of that period was diving inflation. Inflation is now way lower than then, and its risks are skewed to the upside.

Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.




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