Behind The Fed's Not To Worry Stance

From Washington to Bonn to Tokyo, it has been a long-held article of faith that a strong currency is the cornerstone of a robust national economy. Lately, this tenet has lost some credence. Since December, the U.S. stock market has surged to new records and bonds have staged a solid rally, even as the dollar collapsed against the German mark and Japanese yen. Meanwhile, as the mark and yen soared, German and Japanese stock and bond markets headed into tailspins that threaten to seriously stall their economies.

What's going on? U.S. market mavens believe that ignoring the dollar's decline is anything but irrational. Traders say they are focused on U.S. economic fundamentals, rather than on what they see as the symbolic value of exchange rates. The U.S. stock and bond markets are rising on investors' belief that the U.S. economy is in better shape than those of its major trading partners.

FINGER-POINTING. Indeed, investors are betting that Federal Reserve Chairman Alan Greenspan has piloted the economy to the "soft landing." And many economists are shrugging off the dollar's drop as a short-term setback tied to the chronically high U.S. trade deficit, Japan's enormous surpluses, and the fear that another American-financed bailout of Mexico is looming. "This is another of those speculative episodes that often go faster, and reverse faster, than people estimate," says Merrill Lynch & Co. Chief Economist Donald H. Straszheim.

Still, the turmoil has set off a new round of finger-pointing by anxious central bankers, government officials, and overseas investors, who worry that the dollar's stunning 14% decline against the yen and 11.6% drop against the mark this year eventually will lead to a global slump. "The dollar has been a store of value, not just for the U.S. economy but for global wealth and trade," says First Chicago Corp. London strategist Kirit Shah. "It's surprising the U.S. can take such a benign view."

U.S. officials haven't been completely indifferent to the decline: With the dollar hovering around 86 yen, the Treasury Dept. on Apr. 3 and Apr. 5 ordered the Fed into the market to prop up the greenback. Both efforts seemed to have had little effect, convincing traders that the Clinton Administration is trying only to slow the dollar's decline rather than stem it.

CLEAR SIGNAL. To keep German exports competitive, the Bundesbank cut its discount rate half a point, to 4%, on Mar. 30. The Japanese followed with a quarter-point cut in money-market rates. Some analysts think the Bank of Japan, which bought an estimated $15 billion on currency markets in March alone, now may slash its record-low 1.75% discount rate by as much as a full percentage point as early as mid-April.

But so far, the Fed is not even hinting at raising rates to try to prop up the dollar. Its unwillingness to do so--it worries about aborting the U.S. economic expansion--has sent a clear signal to the markets that currency concerns won't drive monetary policy. "The Fed has never believed in targeting the dollar at any specific exchange rate," says a former Fed official.

That attitude, reinforced by Greenspan's willingness to stay on the sidelines, isn't playing well with his foreign counterparts. Many fear that neglect of the dollar by the Clinton Administration and the Fed could endanger the recoveries under way in Europe and Japan--triggering a global recession that would drag the U.S. down as well. Japan may see its gross domestic product nearly stagnate this year. And German officials are "infuriated with the Fed's unwillingness to accept responsibility for the dollar," says one international monetary source. "They feel they were forced into a rate cut by the U.S."

NO INFLATION FEARS. Unless it takes steps to change macroeconomic policy, warn European experts, the U.S. could lose its status as the world's leading reserve currency and see its borrowing costs skyrocket. "The question is, `How long can the U.S. preside over the destruction of its currency?"' asks George Magnus, international economist at S.G. Warburg Group.

But the Fed hasn't felt that pressure to act, at least up to now, because of the lesser role trade plays in the U.S. economy. Germany derives about 20% of its economic output from merchandise exports, and Japan's largest export market remains the United States. That's why both countries feel intense pressure to cut rates to stop their currencies from soaring and making their exports too expensive. Some Japanese analysts think the Clinton Administration won't accede to a dollar-rescue plan until it wrests new trade concessions out of Tokyo.

The Administration may be able to take this stand because it isn't worried that a weaker dollar will fuel inflation. Exports account for less than 10% of U.S. output, and imports of merchandise goods represent another 13%. The Fed presumably saw little risk that the weaker dollar would spark an import-triggered surge in inflation that could wreck the soft landing. While the dollar has fallen steadily against the mark and yen since 1985, the U.S. inflation rate has been heading steadily down. "We are considerably more closed than the globalizers would have us believe--and therefore more able to control our own destiny," Fed Vice-Chairman Alan S. Blinder said in a recent speech.

Truth be told, the U.S. dollar hasn't dropped that much on a trade-weighted basis. With the Mexican peso and Canadian dollar in steep declines of their own, the Federal Reserve Bank of Dallas estimates that the greenback is barely down over the past year.

For now at least, Fed officials seem unwilling to sacrifice the U.S. economy on the altar of global coordination. But with the dollar moving into uncharted waters, further declines could prompt Greenspan to change his mind. That's not out of the question. In the brave new world of currency exchange, the old rules may no longer apply.

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