Divergent Paths in the Internal and External Value of the Dollar
September 2, 2022
Domestic inflation measures shrinkage in the internal value of the dollar. As the general level of U.S. prices rises, a dollar commands less and less value in terms of the amount of goods or services that can be purchased with it. The higher inflation goes, the faster its internal purchasing power shrinks.
The external value of the dollar is measured by movement in the exchange rate. When the dollar depreciates, it takes more units of U.S. currency to acquire foreign currency that is needed to purchase goods or services in other countries. A depreciation of the dollar reduces the external value of U.S. money, while dollar appreciation increases its external value.
It makes intuitive sense for accelerating U.S. inflation to be correlated positively with dollar depreciation, and that correlation also makes sense with simplifying assumptions theoretically over the long run. Such a pattern in fact played out during the decade and a half covering the second half of the 1960’s and decade of the 1970’s. Fixed dollar exchange rates were observed in the 1960’s, and downward dollar pressures in that monetary system was manifested in shrinkage of America’s gold holdings. The dollar’s value late in the 1960’s equaled about 360 yen, 4 Deutsche marks, or $2.40 against the pound sterling. After two formal dollar devaluations first in December 1971 and secondly in February 1973, a modification in the international monetary system occurred in March 1973 that allowed for the dollar’s external value to be set by market forces, with the caveat that central banks including the Fed after June 1973 reserved the subjective right to buy or sell foreign currency to counter disorderly foreign exchange market conditions or to intervene in instances when actual dollar values appeared to deviate substantially from underlying economic fundamentals.
U.S. CPI inflation had averaged 1.9% per year from the end of 1949 through the end of 1964 but accelerated to an average pace of 6.25% over the subsequent fifteen-year period. Inflation came in waves, peaking at 6.2% at the end of 1969, falling back to 2.7% by mid-1972, then running up to 12.3% in December 1974, decelerating to 4.9% in the final two months of 1976, and then advancing to nearly 15% in the first quarter of 1980. Uninterrupted inflation was experienced for 15 months in the second wave and 26 months ending in April 1981 during the third wave.
Increasingly, the U.S. economy seemed stuck in a mutually reinforcing cycle of accelerating domestic inflation and dollar depreciation. Considerable research was conducted at the Federal Reserve and U.S. Treasury into this nasty dynamic particularly to learn the directional nature of cause and effect. Recognition that U.S. inflation could not be conquered without ending the dollar’s propensity to decline came to the fore in November 1978 in the unveiling of a comprehensive dollar rescue package that included bulking up resources to finance direct foreign exchange intervention and a large full percentage point increase in the Federal Reserve interest rate. At the time of that policy initiative, the yen had strengthened to 176 per dollar from 360 in the fixed rate era, and just 1.7 Deutsche marks could be exchanged for a dollar versus four DEM needed back in 1969.
The road back to U.S. price stability took a long time and was very painful. The Fed’s interest rates moved well above 10% and stayed above that threshold well into the 1981-82 recession, and the dollar experienced ups and downs over ensuing decades. The yen, for instance, got as strong as 75/USD at one point. The euro replaced the mark as Europe’s preeminent currency at the start of 1999. Over the subsequent period, the D-mark translation value of the euro got as strong as DEM 1.22 in June 2008 but was also as weak as 2.38 per dollar in late October 2000. The euro touched a 20-year low this week, and the D-mark translation value currently of 1.96 per dollar is closer to its low than its high.
U.S. inflation hasn’t been as high as now in 40 years, but dollar strength has endured. That’s one of the predominant differences between U.S. inflation this time and what happened in the 1970’s. The other striking difference between the episodes is how quickly U.S. inflation accelerated from virtually nothing to almost double-digit territory. Not to put too fine a point on it, CPI inflation went from 0.1% in May 2020 to 9.1% in June 2022. It took a long time in the 1960’s and 1970’s for confidence in policymakers’ ability and will to promote price stability to become squandered. A reason why dollar strength has been maintained this time is that people are assuming that the Fed will not make the same mistake again. In a choice between recession or entrenched inflation, I think officials will opt for recession even if that involves a huge drop in share prices along the way. One benefit of skewing the central bank reaction function toward restraint is that a strengthening dollar will depress import prices and facilitate the shedding of inflation. That’s what happened in 1981-84 when the dollar doubled from DEM 1.70 to DEM 3.47.
Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
Tags: dollar and inflation
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