Don't Sweat The Dollar's Swoonby
Here's an astounding fact: Last year, the U.S. required a record $315 billion in fresh foreign capital to balance its international accounts. That's in addition to the new funds needed for domestic uses, especially the $203 billion used to finance last year's federal budget deficit. And people wonder why the dollar is weak.
But does the dollar's recent swoon matter much to the economic outlook? The short answer is: Not really. The inflationary implications will be small, as will the effect on overall trade flows. And the dollar will not play a big role in determining where the Federal Reserve will set interest rates. It never has.
What about all that foreign capital? It will continue to flow in as we need it. As bad as America's debt problems are, the U.S. is nowhere near the combination of fiscal irresponsibility, rampant inflation, and deficient competitiveness that would cause foreign investors to lose confidence in dollar-denominated assets. In fact, on all three of those counts, the outlook is improving.
The dollar's long-term decline against some major currencies has occurred partly because of our heavy debt levels. But the greenback's recent tumble vs. the mark and the yen goes beyond reason. Based on the dollar's relative purchasing power, economists at DRI/McGraw-Hill Inc. estimate that the dollar should trade closer to 1.9 marks instead of 1.4, and at least 112 yen rather than 90. Of course, currency traders rarely listen to economists.
BUT EVEN INCLUDING the plunge relative to the mark and yen, the greenback shows no weakness when compared with a trade-weighted basket of currencies (chart). Take the index compiled by First Chicago Capital Markets Inc. It covers 21 countries in the Organization for Economic Cooperation & Development. On Mar. 21, it stood 6.4% higher than on Dec. 1.
That index shows how the dollar's strength relative to the Canadian dollar and the Mexican peso has offset its weakness vs. the mark and the yen. Moreover, the index of the Federal Reserve Bank of Dallas, which uses 99 countries and adjusts for each nation's inflation rate, tells much the same tale. This broader, more stable view of the dollar is the reason why its recent gyrations will have little impact on either growth via exports or inflation via higher import prices.
The biggest impact on U.S. exports this year will come from the collapse of the Mexican economy. The hit is coming faster and sharper than anticipated. Seasonally-adjusted exports headed south of the border fell $0.5 billion in January. And based on Mexican data, they fell at least $0.5 billion in February (chart).
In February, Mexican imports--about two-thirds of which come from the U.S.--plunged 26% from December, when the peso crisis exploded. Already, Mexico's trade balance has swung from deficit to surplus in February for the first time in seven years. And with a severe austerity plan in place, Mexico will cut its purchases of U.S. goods even more throughout the year.
THE DROP in exports to Mexico was partly to blame for the deterioration in the U.S. trade deficit in January. The gap for goods and services widened to $12.2 billion, far above expectations, after narrowing to $7.3 billion in December. For goods alone, the deficit hit $17.2 billion, the highest ever. The overall January gap implies a wider deficit this quarter compared with the fourth quarter, causing a drag on economic growth.
Exports dropped a steep 4.6%, to $60.7 billion, while imports hit another record, rising 2.9%, to $72.9 billion. Imports of capital goods were up, a sign of strong U.S. capital spending, and consumer goods also rose, suggesting that retailers are betting that the recent slowdown in consumer spending is only temporary.
After the trade data's release, the dollar weakened slightly vs. the mark, and even though the U.S. trade deficit with Japan narrowed, the greenback also fell against the yen.
But it's not just the trade deficit that worries the currency markets. The gap is set to improve in 1995, as imports slow in response to cooler domestic demand. But at the same time, the overall current-account deficit, which hit $155.7 billion in 1994, may continue to widen. That's why traders are selling dollars.
The current account is composed of the trade balance, net investment income, and certain government transfers. Last year, for the first time on record, the U.S. paid out more investment income to foreigners than it earned, reflecting the soaring cost of financing the U.S.'s huge stack of IOUs.
Much of the interest we shipped abroad in 1994 went to cover government debt. But even on that score, the outlook is improving. The Treasury said the federal deficit in March was $38 billion, bringing the gap for the first five months of the fiscal year to $94.1 billion. That's 20% below the same period last year.
Although delays in tax refunds may be boosting receipts, the fiscal 1995 deficit could come in below the Congressional Budget Office's projection of $176 billion. Moreover, the Senate appears to be placing first priority on spending cuts rather than tax cuts.
ONE THING dollar bears need not fret over is U.S. inflation. Rising inflation weakens a currency because it erodes the currency's buying power. But right now, the price indexes remain tame, and slower economic growth will hold future price pressures at bay.
The consumer price index rose 0.3% in February, as did the core CPI, which excludes energy and food. Annual consumer inflation stood at 2.9% in the month, with the core rate at 3%. February producer prices for finished goods are also benign, though inflation at the earlier stages of processing is on the rise.
However, some of those pressures are easing. Nucor Corp., the world's largest minimill steelmaker, has cut its steel prices, suggesting that the previously announced hikes are not sticking, and commodity prices for metals generally are falling.
The inflation outlook is further enhanced by continued signs that the economy is cooling off. In particular, the housing and auto sectors are sagging. Housing starts dropped 2.6% in February, after a steep 12% decline in January. Builders already have a load of unsold homes, and a March survey shows that buying conditions continue to deteriorate (chart).
Weaker car and truck sales and rising dealer inventories have caused Detroit to slash its spring-quarter production plans. Ward's Automotive Reports says that in February, dealers held a 76-day supply of cars and trucks at current sales rates, well above the more desirable 60-day supply.
As evidence of slower growth and low inflation mounts, the Fed has no domestic reason to hike rates. That means raising rates in support of the dollar would be counterproductive to the Fed's soft-landing goal. If the Fed were to take such a risk, it would be time to worry that the dollar's weakness reflects a serious breakdown in our economic fundamentals. But for now, if the Fed isn't concerned, you shouldn't be either.