Jeremy Siegel, Ph.D. The Future for Investors

The headlines are just plain depressing. The dollar falls to a record low of $1.60 per euro, nearly half its value six years ago, and sinks below 100 Japanese yen. Even the lowly Canadian dollar recently traded above its southern counterpart for the first time in over three decades. 

Many blame the recent surge in commodity prices and other assorted ills on the plunging dollar. Despite this, the official position of the Bush administration, as voiced through Treasury Secretary Henry Paulson, is that the government favors a “Strong Dollar Policy.”

Yet policymakers seem to do nothing to keep the dollar strong. And the recent policy statement by the Federal Reserve, although hinting that there may be no further rate cuts, may not be enough to keep the dollar from plunging further.

What is the real story of how the dollar impacts our economy and should the government take steps to support our currency?

Some Exchange Rate Basics

Ever since the breakup of the fixed exchange rate system in the early 1970s, exchange rates of the major currencies in the world have been largely determined by supply and demand in free foreign exchange markets.  The demand for dollars is determined by foreign demand for US exports and US capital, while the supply is determined by our demand for foreign goods and foreign capital. The dollar has fallen over the past year for many reasons; but most important are the Fed’s reduction of interest rates, the slowdown in the US economy, and the surge in US petroleum imports, which increases the supply of dollars on the currency markets.

The falling dollar worsens inflation by increasing the prices of imported goods.  Over the past year, crude oil has nearly doubled to almost $120 per barrel, a much larger increase than oil’s price in euros or yen. Furthermore, the prices of imported goods from salmon to copper to cocoa have increased sharply as the dollar sank. 

The falling dollar is not all bad.  It has been a major factor in increasing US exports at a 10% annual rate over the past several years.  And, despite disappointing trade data for February, our trade deficit appears to have peaked at $67 billion in August 2006 and has since been trending lower. 

Furthermore there is no question that the profits from non-US sales are among the bright spots in first quarter’s US corporate earnings reports as those firms with large international exposure have far outpaced those that rely on slumping US demand.  If you are in the export business, there is no question that the falling dollar brings a smile to your face.

But in general the benefits of a falling dollar do not outweigh the negatives.  We are all consumers who suffer from higher imported prices while the gains from a weaker dollar are concentrated in a much smaller group of exporters and internationally-oriented firms.  Even stockholders might not gain as rising inflation raises interest rates and raises the effective tax on capital gains which are not adjusted for the inflation.

Policies to Support the Dollar

If a falling dollar hurts more than it helps, why doesn’t the government pursue policies to strengthen the dollar?  The simple answer is that to do so would require a reversal of the Fed’s easy money policy designed to combat the financial crisis. Although the Treasury Department has formal jurisdiction over the dollar exchange rate, in today’s capital markets the Treasury can do very little to change the dollar’s direction without help from the Fed.

The reason is that markets have changed. Long gone are the days when governments could buy a few billion dollars of their currency in the foreign exchange market to raise exchange rates.  In today’s global markets, hundreds of billions of the dollars would be needed to effectively boost the greenback.  The only way to attract that capital would be to raise the reward from holding the dollar – specifically boosting short term interest rates, which is under control of the central bank, not the treasury.  Given the current weakness of the US economy, raising rates would be a tough choice for the Fed.

I have always been a fan of market-determined exchange rates, free of government interference.  The collapse of the dollar is a symptom rather than a cause of our current problems.  In order to help our economy pull out of the credit crisis, the Fed has vigorously pursued an easy monetary policy by lowering short-term interest rates and increasing the supply of credit.  This policy has stabilized the financial system, but it has also fed the current commodity price surge and decline of the dollar.

All told, we do need to worry about the plunging dollar.  We are now at the point where the Fed has done enough to stimulate the economy by lowering interest rates and must turn its attention to the inflationary implications of the sinking dollar. I hope that the recent hints that Fed is done easing are enough to strengthen the dollar.  But if they are not, the Fed must reverse direction and raise interest rates.  Ultimately price stability will benefit our economy far more important than the short-term stimulus of another rate cut.