The declining dollar
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.