The de­clin­ing dol­lar

The Washington Times Weekly - - Editorials -

As re­port af­ter re­port con­tin­ues to con­firm that the U.S. econ­omy has en­tered a pe­riod of rel­a­tively tepid growth, the dol­lar has come un­der in­creas­ing pres­sure, fall­ing to new cycli­cal lows that de­fied ex­pec­ta­tions ear­lier this year.

Not even the Nov. 29 up­ward re­vi­sion in third-quar­ter growth (from 1.6 per­cent to 2.2 per­cent) could stem the tide against the dol­lar. In­vestors soon re­al­ized that the change was mostly due to busi­ness in­ven­to­ries pil­ing up, a de­vel­op­ment that does not augur well for fu­ture out­put. Af­ter strip­ping away changes in private in­ven­to­ries, which yields fi­nal sales of do­mes­tic prod­uct, the econ­omy has grown at an an­nual rate of 2.1 per­cent dur­ing each of the two pre­vi­ous quar­ters. That is sig­nif­i­cantly be­low the 3.8 per­cent av­er­age an­nual growth rate of fi­nal do­mes­tic sales achieved dur­ing the four pre­ced­ing quar­ters, which in­cluded last year’s Ka­t­rina-af­fected fourth quar­ter, when fi­nal do­mes­tic sales ac­tu­ally de­clined.

Fol­low­ing the Dec. 1 re­ports re­veal­ing that con­struc­tion spend­ing had fallen much more than ex­pected in Oc­to­ber and that man­u­fac­tur­ing had con­tracted in Novem­ber for the first time in more than three years, the dol­lar reached a 20-month low against the euro and a 14year low against the Bri­tish pound. De­spite the pre­dic­tion two weeks ago by Fed­eral Re­serve Chair­man Ben Ber­nanke that the U.S. econ­omy was on tar­get to reach the highly prized soft land­ing and not­with­stand­ing Trea­sury Sec­re­tary Hank Paul­son’s in­sis­tence that “a strong dol­lar is clearly in our na­tion’s best in­ter­est,” mar­kets con­tin­ued to as­sault the green­back with im­punity. Ac­cord­ing to a Fed-com­piled, in­fla­tion-ad­justed, trade-weighted “broad in­dex” of the for­eign-ex­change val­ues of the dol­lar, Novem­ber’s av­er­age dol­lar value reached its low­est point in more than nine years. And that was be­fore Fri­day’s de­te­ri­o­ra­tion.

Mean­while, eco­nomic growth in the eu­ro­zone is pro­ceed­ing at a pace that is faster than was ex­pected ear­lier this year. The changes in rel­a­tive growth rates partly ex­plain why the dol­lar has been fall­ing so steeply against the euro. An­other im­por­tant fac­tor has been the nar­row­ing of the short-term in­ter­est-rate spread be­tween the dol­lar and the euro and the in­creas­ing be­lief that euro in­ter­est rates are headed up­ward and dol­lar rates will likely re­main flat be­fore be­gin­ning to fall.

It may also be that the dol­lar has sim­ply re­sumed its long-term de­scent, which many economists be­lieve is nec­es­sary to ad­dress Amer­ica’s soar­ing trade deficit. Ac­cord­ing to this ar­gu­ment, the U.S. trade deficit in­creased from $96 bil­lion (1.3 per­cent of gross do­mes­tic prod­uct) in 1995 to $363 bil­lion (3.6 per­cent of GDP) in 2001 as the dol­lar ap­pre­ci­ated by 28 per­cent in in­fla­tion-ad­justed terms (broad in­dex) be­tween 1995 and 2001. The dol­lar be­gan to de­pre­ci­ate in early 2002, fall­ing 16 per­cent by the end of 2004. Nev­er­the­less, in part be­cause the U.S. econ­omy was ex­pand­ing faster than the eu­ro­zone and Ja­pan, the U.S. trade deficit con­tin­ued to rise, reach­ing $618 bil­lion (5.3 per­cent of GDP) in 2004.

The trend in the de­clin­ing dol­lar was re­versed in early 2005, as the U.S. econ­omy con­tin­ued to grow faster than the eu­ro­zone and Ja­pan and as the Fed stead­fastly raised short-term in­ter­est rates, even­tu­ally lift­ing its tar­get overnight rate from 1 per­cent in mid-2004 to 5.25 per­cent two years later. The dol­lar’s 10month re­bound (5 per­cent) peaked in Oc­to­ber 1995 (in­fla­tion-ad­justed broad in­dex), and the green­back has fallen nearly 7 per­cent since. Mean­while, the trade deficit is on track to ex­ceed $780 bil­lion (5.9 per­cent of GDP) this year.

To re­verse this un­sus­tain­able trend in the trade deficit, the dol­lar would al­most cer­tainly have to fall sig­nif­i­cantly more. The de­cline may not be be­nign. In­deed, if cen­tral banks in Asia and oil-ex­port­ing coun­tries de­cide to shift their soar­ing for­eign-ex­change re­serves from dol­lar­de­nom­i­nated fi­nan­cial as­sets into other cur­ren­cies, such as the euro, then a ma­jor source of dol­lar strength would dis­ap­pear, per­haps set­ting off a rush to dump dol­lars as the green­back plum­mets. That could get ugly quickly.

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