Defend the dollar

Posted: Dec 11, 2003 12:00 AM
At this week's monetary-policy meeting, the Federal Reserve took the first baby step toward making small interest-rate increases next year. The central back acknowledged that deflation is no longer a problem and that the economy is growing briskly. Wisely, the Fed appears to be taking account of forward-looking market indicators, such as rising gold, higher raw-material commodity prices and a declining dollar, all of which signal that the obstacle of deflationary price declines has been removed and that world economic recovery has begun. Next year, the Fed will slowly narrow the 1 percentage point gap between the fed funds policy rate and the economy's natural rate. Expect a few half-percent rate hikes, which will still leave ample liquidity to accommodate the economic recovery. These moves will stabilize inflation expectations and long-term bond rates, bolstering the rise in stocks and the economy. The other economic task at hand is to stabilize the dollar, which has been under pressure in foreign-exchange markets and has overshot a normal market correction. But there's no need to panic, as the financial headlines suggest. Up to now, the falling dollar hasn't really been a bad thing. The original public offering of the euro came at the start of 1999 at just under $1.20. Now it's back to $1.22 -- a round trip. The yen, meanwhile, has strengthened about 20 percent over the past two years. Supply-side mentor Art Laffer attributes the currency swings to changes in real capital returns among the euro, yen and dollar. When inflation-adjusted Treasury rates surged above 4 percent during the last economic boom, the dollar overshot way too high on the upside. (Tight money from the Fed contributed to this.) Today's real Treasury rate is around 2 percent. That's respectable, but way below the prior peak. Hence, for-ex markets have lowered the dollar's exchange rate. But as the nascent business recovery gathers steam at home, the real rate will probably rise to 3 percent over the next year or so. The market's downward dollar adjustment should be ending. Meanwhile, economic policies in Japan and Europe appear to be somewhat improving. Koizumi is deregulating in Japan; Chirac and Schroeder are trying to lower taxes and deregulate in Europe. The euro appears to be in capable hands with Jean Claude Trichet, the new head of the European Central Bank. The essential point to remember is that currency swings are mirroring growth policies and real capital returns among the big three economies. In addition, the terms of trade are improving for the long-depressed European and Japanese economies. Our foreign counterparts are getting healthier, which is reflected in their upward currency moves. Laffer also believes that the shift in real exchange rates will sharply lower the current-account trade deficit in the United States from nearly 5 percent today to roughly 2 percent in the next few years. This would be a constructive development for world economic stability. So far, there are no serious inflationary consequences to the world currency adjustment process. Core import prices in the United States are only 0.7 percent over the past year. Consumer prices are slightly above 1 percent, and wholesale prices are about flat. Business hard-good prices have actually fallen 3 percent. Lower tax rates, rising productivity and faster growth are all counter-inflationary. As the dollar has declined, gold has jumped slightly over $400. But in constant 2000 dollars (to adjust for changing production costs), gold has descended steadily from $1,207 at the hyper-inflationary peak in 1980 to $364 in today's near-zero-inflation environment. That said, U.S. policymakers should take care to avoid another 20 percent drop in the dollar and rise in gold. That might tempt inflationary forces that could undermine America's strong economic recovery. Markets have a tendency to overshoot, so every now and then central banks and finance ministries can take limited steps to reinforce policy goals and promote two-sided markets. Traders have gotten way ahead of themselves by constantly shorting dollars and buying gold. This trade should not be a sure thing. More, if the yen and euro keep appreciating,
deflationary barriers to economic recovery will be recreated in Japan and Europe. Now would be a good time for the Fed and Treasury, perhaps working with their G-7 counterparts, to signal world markets that the currency adjustment has gone far enough -- although the Fed's statements this week suggest the central bank is already fighting for the dollar. If monetary authorities in Japan, Europe and the United States intervene in currency markets to defend the dollar, it would send a shot across the for-ex bow. Then a new period of currency stability would arrive, accelerating world economic recovery.