Oct 04 2007
The dollar carries on falling
States in both Asia and the Middle East are buying fewer dollar assets. Some appear to be selling dollar bonds, and some are severing their currency links with the falling dollar. The Fed’s decision to cut rates by 50 basis points recently will accelerate this process. Some commentators seem alarmed by these developments.
The falling dollar does not make the Fed’s decision wrong. There were good domestic reasons why the Fed needed to relax the credit squeeze. Overseas governments have to make their own portfolio decisions in the light of dollar interest rates compared to other possible investments.
It is healthy that the dollar falls somewhat, to help correct the US balance of payments further. The US needs to divert more activity into exports, which a softer dollar will do. Middle eastern countries worried about their own credit and money expansion will benefit from revaluing against the dollar, which will automatically tighten their monetary conditions to head off worse inflation. There also needs to be further appreciaiton in some Asian currencies to create better balance in the trade accounts with the west.
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
This is all very interesting but the little guy like me worries about a sterling bubble building up and bursting.
Then we get inflation and trapped between a rock and a hard place with interest rates.
People seem to want our money at the moment but we aren’t exactly a reserve currency are we? Any more shinanigans like Northern Rock, any sign of a slide in the housing market and foreign investors might start to think of sterling as a ’sell’, or even worse a ’short’.
Reply: The pound is going up against the dollar becuase the dollar is very weak, but it is not going up against the stronger currencies. The pound is also gaining some support from relatively high interest rates here. The problem is more credit crunch than incipient inflaiton at the moment.
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This is a very complicated issue and of course no-one can predict exactly how things will turn out. The passive devaluaton of the dollar combined with a reduction in interest rates are in textbook terms measures that will lead to inflation. The Americans no doubt have their rationale for allowing this. John, your logic on the need to promote exports is sound. The question is how low can the dollar go? I’ve read a number of commentators say that the Fed are only looking for one more rate cut, but what if that proves to be still not enough? No-one can rule out inflation and I believe the same applies in Britain because no-one really knows the true rate of inflation with Gordon Brown keeping two sets of books and an overvalued sterling keeping the lid on things.
John, just want to ask you if you agree that most of Britains economic problems have come about since the end of Bretton Woods?
reply: No I don’t think that. I favour floating exchange rates to help economies make adjustments to different rates of inflaiton, growth and investment opportunity. No-one can rule out inflation, but I do think the issue in the US at the moment is staving off too sharp a decline in growth.
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Not sure you’re right, John. On the face of it, credit crunch plus loosening would mean tendency towards slowdown & inflation in the US - ie, a flirtation with stagflation. If so, this would be the worst possible outlook for the dollar. And yet, although the dollar ‘carries on falling’ it just hasn’t collapsed as one would expect if that were all that’s going on.
Three possibilities:
1. The dollar has been falling for two years in anticipation of what’s now emerging.
2. We’re wrong about US slowdown and/or inflation in the medium term.
3. The interbank seizures challenged the justified expectation of permanent available liquidity in dollar asset markets, which forms one major necessary plank in the dollar’s reserve currency status. In these circs, the Fed’s loosening reaffirms the dollar as a reserve currency and so, perversely, strengthens it.
I suspect there’s a bit of all three going on. The big surprise would be a US domestic economy which didn’t roll over next year, combined with a currency which subsequently rallied strongly. And I think we just might get it. In which case, Steven-L’s worries about a sterling problem exposing our lost supply-side flexibility might be absolutely right.
PS. As I’m sure you know, a falling dollar won’t deal with the US current account deficit, and a rising Rmb won’t deal with China’s current account surplus.
Reply: Stagflation would be a bad outcome, but I do not think inflation is currently a worry in the main Western economies. There are no signs of a wage/price spiral. Manufactured product is still being forced down in price by world competitive forces, and service activities are in the main under reasonable control thanks to web technology and reasonably flexible markets in the US. I agree the dollar could draw strength from a decent growth performance next year. I do think a lower dollar will help cut the deficit.
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