How the Dollar Performed in Previous Downward Cycles of the Fed’s benchmark Interest Rate
September 17, 2024
The mystery concerning tomorrow’s initial easing by the Federal Reserve concerns the size of the interest rate cut. Will the reduction be 25 basis points or 50 bps? First cuts made in July 2019, September 1998, July 1995, June 1987, August 1984, December 1974 and November 1970 were each moves of 25 basis points in size. The first reductions done in October 1987, January 2001, and September 2007 amounted to 50 basis points. The backdrops to directional rate reversals in those three occasions when the first cut was larger than a quarter percentage point were a 22.6% single-day drop in the DJIA on October 19, 1987, a domestic recession late in 2000, and the subprime mortgage banking crisis that began in 2007.
Looking further back in time, cycles of loosening monetary policy began with a 25-basis point cut in November 1970, December 1974, and August 1984. Easing cycles that were initiated with moves of more than 50 basis points occurred in May 1980 when credit controls were imposed and in July 1982 when the Fed began throttling back its discount rate after a whole year of maximum monetary restraint in the face of significant recession.
Monetary policy can influence real economic activity by affecting the cost of borrowing needed to fund business investment and large household purchases. An alternative back-door channel of influence impacts growth and inflation through currency movements. While domestic interest rates measure the internal price of money, exchange rate changes reflect movement in the external cost of money.
The U.S. price maelstrom of the 1970s, which was stemmed in the 1980s by an in an extremely restrictive monetary policy under the leadership of former Fed Chairman Volcker, had been fanned by a reinforcing vicious cycle of domestic inflation and dollar depreciation. Understanding the connection between those interrelated forces was a key to addressing the problem properly. That epiphany actually happened in November 1978, 10 months before Volcker was promoted to Chairman, when a package of measures to support the dollar, including a sharp interest rate hike and the massive enhancement of resources that could be utilized to fund direct U.S. intervention in currency markets. When a commitment to a stronger dollar was later supplemented by a reinvented framework for U.S. domestic monetary policy with a focus on reducing money growth, the road back to price stability began in earnest.
As a parenthetical note that has been seemingly missed in this year’s presidential debate, the spike in U.S. inflation during 2021-22 was not paralleled by a simultaneous sharp depreciation of the dollar. This fact separates the two experiences in a fundamental way. Double-digit U.S. inflation in the 1970s and early 1980s was fed by excess demand, and U.S. inflation then was higher than in many other industrial economies. In the more recent experience, a huge supply-side shock related to Covid, rather than a general excess of aggregate demand, provided the big bang to that inflationary episode. U.S. inflation this time around was matched, if not exceeded, in other countries, and it did not take over a decade for Federal Reserve officials to get ahead of the problem.
Many U.S. voters remain angry because price levels never went back to pre-2021 levels. A complete reversal of prices didn’t happen in the 1980s and 1990s, either, and that’s not what is meant by price stability. The goal of policy is, and rightfully ought to be, not a specific level of prices but rather a steady, sustainable rate of price growth, averaging 2%. When prices are falling as rapidly as they rose in the 1970s or at peak momentum in 2022, a deep state of deflation has taken root, the kind that would put the United States in danger of falling into a major depression. With 20-20 hindsight, the Fed might have put on the brakes sooner than it did, but monetary officials have done a far better job than their forebears of the 1970s. Few economists thought this task could be done without some period of recession, and that rare scenario still remains achievable.
If the recent spike in U.S. inflation had merely been a variation on the problem the Volcker had successfully handled, one could reasonably expect the coming cycle of Fed interest rate reduction to be associated with a broad depreciation of the dollar. Between late 1980 and February 1985, the dollar roughly doubled in value against the German mark when Fed policy was kept tight but then dropped from 3.48 marks per dollar back to DEM 1.58 by the end of 1987.
This time around, many central banks will be loosening their monetary purse strings in tandem, and there will be one major monetary policy, the Bank of Japan, that will be transitioning in the opposite direction. There are numerous other variables that are different now than then. Still, having information about how the dollar behaved during prior easing cycles ought to hold some value, so here goes.
- The Fed’s interest rate target in the four months from October 1987 to February 1988 was cut initially by 50 basis points and altogether seven-eights of a percentage point. In that span, the dollar fell 5.5% against the German mark and 9.7% versus the yen.
- From June 1989 until September 1992, an easing cycle that began with just a 25-basis point drop but eventually totaled 675 basis points, the dollar slumped 27% against the mark and 12.7% relative to the yen.
- The easing cycle from July 1995 to end-January 1996 was just 75 basis points in total, yet the dollar experienced wide swings of -20.9% against the mark and +25.4% vis-a-vis the yen.
- Another 75-basis point cycle of interest rate reduction in the two months between September and November 1998 was associated with a 0.7% uptick against the mark but a 10.2% concurrent loss relative to the yen.
- In the period between January 2001 and June 2003 when the federal funds rate was slashed from 6.5% to 1.0%, the dollar sank 17.7% against the euro while firming 2.9% against the yen.
- U.S. banking excesses caused the Great Recession, but the U.S. economy weathered that storm better than most industrialized countries.The federal funds target was lowered from 5.25% in September 2007 to 0-0.25% by end-2008, and the dollar while that happened managed to rise 1.0% against the euro and 6.6% versus the yen.
- The most recent downward cycle in the Fed’s benchmark interest rate from 2.5% in July 2019 to 0.25% in mid-March 202o saw scant net movement in the dollar, dips of just 1.0% against the euro and 1.4% relative to the yen.
Copyright 2024, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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