Treasury Secretary Lawrence H. Summers has taken on a tricky balancing act: The U.S. decided to assist other governments in the Sept. 22 currency-market intervention aimed at propping up the euro at the cost of a weaker dollar. But at the same time, Summers must continue to assure foreign investors that the U.S. remains committed to a strong greenback.
The two goals are at cross-purposes when much is at stake, both economically and politically. A brawny dollar is important right now because the U.S. requires an unprecedented flow of foreign capital to finance growth, especially in business investment. Equally crucial, the dollar has been a key anti-inflation force. A sudden weakening in the currency would have sharply negative consequences for U.S. growth and inflation. That's why the Treasury Dept. made it clear that the intervention was initiated by the euro zone, not the U.S.
Recent economic reports highlight the risks of dollar depreciation. First, inflation pressures are not abating. While the strong dollar has restrained goods inflation, service inflation is picking up noticeably, and that's apart from the runup in energy prices. Also, because of a Labor Dept. calculation error, announced on Sept. 27, measured inflation is actually a smidgen higher than previously reported. Plus, household demand appears to have regained considerable strength in the third quarter.
Moreover, the July widening in the trade deficit highlights the growing need for foreign capital (chart). The July data follow a second-quarter report showing that the current-account deficit--which includes trade in goods and services plus net payouts of investment income to foreigners and other foreign transfers--ballooned to a record 4.3% of gross domestic product. Across all of Latin America, the deficit is about 3%.
MAKE NO MISTAKE, if any country can carry foreign obligations that large, it's the U.S., given its wealth of New Economy investment opportunities. That's one factor bolstering the near-term outlook for the dollar. For another, Japan shows few signs that its growth is self-sustaining without government stimulus, so the yen remains hobbled. Plus, currency intervention in Europe, even with the support of the U.S., is unlikely to buoy the euro in a lasting way.
History has shown that intervention works only if market forces are ready to operate in the same direction as the government currency actions. However, two negative fundamentals argue for euro weakness. First, European growth is apparently slowing in the second half relative to expected U.S. growth. And second, Europe is making only slow progress on the reforms needed to enhance its productivity.
Also, it remains to be seen to what extent the European Central Bank is willing to back up its currency operations with higher interest rates. Without that, the currency operations will have no lasting impact, beyond any immediate psychological payoff.
Still, the risks of a future weakening in the dollar are unlikely to go away as long as the trade deficit keeps widening. The July gap rose to a record $31.9 billion, well above the $29.7 billion second-quarter average. The deficit in coming months will rise even more, thanks to costlier imported oil.
However, the nonoil gap is widening as well, and that pattern won't change soon. That's because the current strength of the dollar and expected slower growth in Europe means U.S. export growth may well be peaking about now.
AT THE SAME TIME, imports could continue to surge in response to a pickup in U.S. demand. In particular, the latest data indicate that the consumer and housing sectors have bent but not broken under the tighter grip of higher interest rates and pricier energy.
If anything, the two sectors began to rebound in the third quarter. Existing home sales bounced back by 9.3% in August, recouping almost all the ground lost in July. Resales logged in at an annual rate of 5.27 million, just slightly below their year-ago pace.
Lower mortgage rates are credited for the rebound, but housing demand is staying the course because consumers are still quite upbeat about the economy (chart). The Conference Board's index of consumer confidence increased to 141.9 in September, from 140.8 in August.
Consumers are more optimistic about both the economy's current situation and the outlook for six months down the road. And despite two seemingly weak employment reports in a row, 53% of households still view jobs as "plentiful," down only a bit from 53.5% in August and 55.8% in July.
Economic enthusiasm among consumers seems a bit surprising in light of two pins that usually burst the consumer bubble: higher interest rates and oil prices. Instead, says Lynn Franco, director of the Conference Board's Consumer Research Center, "despite higher gasoline prices this summer and the prospect of higher heating oil costs this winter, consumers remain in an upbeat mood. Nothing in this latest survey suggests the economy will run out of steam soon." If that's the case, then the economy will need all the inflation-fighting help it can get from the dollar and global producers, because domestic spending may rev up to a pace that exceeds the potential gains in supply.
MOREOVER, BETTER TIMES are spreading across more of the income spectrum. The Census Bureau reports that the 1999 poverty rate dropped to 11.8%, a 20-year low, and real median household income rose for the fifth year in a row, to a record high of $40,816.
Bolstered by rising incomes and tight job markets, real consumer spending appears to have grown at an annual rate of about 4.5% in the third quarter. The pace could be even higher given the solid gains for September as reported in the weekly retail surveys.
A consumer rebound could be a problem for the inflation outlook. In statements following its recent policy meetings, the Federal Reserve has repeatedly warned of the widening gap between robust demand and potential supply. And while economists expect policymakers to keep short-term interest rates unchanged at their Oct. 3 confab, look for another reiteration of the inflationary dangers of the demand-supply gap.
Certainly, manufacturers are seeing no end to copious demand. New durable-goods orders increased 2.9% in August, and unfilled orders, excluding the volatile aircraft sector, remained near their record high (chart). Faced with an increasing number of customers, producers may see an opening to hike prices heading into 2001.
The danger is that rising pricing power at home may roll in at the same time that a weaker dollar could introduce price pressures from abroad. That's just the kind of inflation trap that Summers and the economy must avoid if the U.S. is intent on helping an ally deal with its slumping currency.