Because Of Inertia, The Dollar Will Keep FallingRudi Dornbusch
Early this year, the prospect of a steep dollar rise was very good. Now the dollar is in the tank: It has reached an all-time low against the yen and is on the way to a low against the mark.
Four factors determine the performance of a currency: an economy's external balance, the relative cyclical position of a country's economy, the relative level of interest rates, and general investor appeal. Of course, most of the time these factors don't all point in the same direction. That makes for large swings in perception: The same interest-rate level that one day seems high and rewarding is deemed the next day to barely compensate for risks.
Fundamentals--deficits, cyclical positions, interest rates--all can be enlisted to explain a currency's strength, especially after the fact. But they must be given shifting weights to help explain currency movements. Moreover, market psychology plays an important role. Surveys of investor expectations reveal that foreign-exchange markets systematically extrapolate recent trends--a currency that has been depreciating is expected to continue depreciating over the near term. Over longer horizons it is expected to make a comeback. The dollar is on one of these trips, driven down by the general assumption that there is nothing to keep it up--neither fundamentals, including Federal Reserve interest-rate hikes, nor strong intervention.
Exchange-rate movements can get out of hand, with speculative opinion as an important driving force. The best example is the U.S. dollar in the 1980s: From the late 1970s to 1985, the dollar rose against the mark by nearly 100%. The increased investor appeal of early Reagan vs. late Carter, recovery from a deep recession, and high interest rates made the dollar a hot asset. Then, overreaching itself, the dollar started a slide against the mark that continued for the next five years.
NO RESTRAINT. The reason there was a good prospect for a dollar rally earlier this year was that Europe's economies were weak and Japan was mired in a prolonged slump. In the U.S., a boom seemed to emerge with rising interest rates on the horizon. But by now, U.S. erowth is old news and can't carry the dollar any further. In Germany, the mighty mark is on the rise. Angst has given way to outright euphoria, pointing to a possible reelection of Helmut Kohl's coalition government. In Japan, the slump has yielded to consumer spending. Growth is around the corner. Interest-rate cuts abroad are unlikely now, while in the U.S., rate increases are slow to come.
On the interest-rate front, the dollar has received little support at home. The Clinton Administration has come out repeatedly against higher interest rates even though the economy is now at 6%, which in the U.S. is reckoned as full employment. Congress has cautioned the Fed against interest-rate rises. Moreover, although fiscal restraint would be highly appropriate, it has been ruled out on political grounds.
Dollar support thus has eroded both in terms of interest-rate differentials and the cyclical position. That leaves the large U.S. current-account deficit as a focal point--more so as it widens once again under the impact of a boom. Moreover, the rise of the yen against the dollar is also appropriate in light of the evolution of U.S.-Japan trade talks. It's now clear the Administration will settle for anything, anything at all, just to get a deal. Anything at all means practically nothing. Thus, if a trade opening is not about to happen in this decade, more work needs to be done through the exchange rate to correct Japan's imbalances. One more reason then for a strong yen.
TEPID RESPONSE. The remaining factor--investor enthusiasm--gives the dollar little support. The President is weakened by his personal problems, by being caught up in a health-care agenda, by a foreign-policy posture that hardly inspires confidence. None of this offers comfort to investors. And if these factors weren't enough, the tepid response of the Administration to the dollar slide--halfhearted intervention--has done the rest.
What is needed is a forceful, coordinated intervention that puts a floor under the dollar. The only way to get there is to accompany the move with higher U.S. interest rates. Fed funds would have to be pushed up by 75 or even 100 basis points to make a major difference. Much of the work must come from the New York Fed, but some extra help from Germany and Japan would do well to both lock in the dollar and help ease long-term bond and equity markets. Neither in the U.S. nor abroad is there any enthusiasm to make currency rates the central focus of monetary policy. That leaves the dollar on the skid.
No one wants to be blindsided by another move of a currency that is selling mff. Just as in the 1980s, we may get an overshooting situation where exchange rates move very far away from fundamentals. Too much of a dollar depreciation will push the U.S. beyond full employment and into early, unnecessary inflation. Abroad, it may put in question recoveries that are just emerging. Don't the currency speculators know all that? On the evidence of the 1980s, probably not.