Thursday, October 25, 2007

Why the Dollar Will Continue to Decline

The article below from the WSJ is a well-reasoned argument for why the US dollar will continue to decline for some time to come. Test in bold is my emphasis.

Nearly every day in recent weeks seems to bring news that the dollar has fallen to record lows against the euro and other major currencies. Important factors include the Fed's bold -- but appropriate -- 50 basis-point cuts in the Federal Funds rate and the discount rate, and the policies we are likely to see in coming months from the European Central Bank and the Bank of England.

But to really understand the dollar's future prospects, we must view its recent decline in the broader context of events over the past decade.

As the nearby chart shows, since 2001 there have three distinct phases of what I have called the dollar downdraft. From 2001 though the spring of 2004, there was a trend decline in the dollar against the currencies of other major countries. This occurred during an initially sluggish U.S. recovery and an aggressive ease in Fed policy that drove the fed funds rate down to 1% and kept it there for a considerable period.

In 2004, as the U.S. expansion was robust, productivity growth remained strong, and the Fed began hiking interest rates to normalize policy "at a measured pace," the dollar downdraft was put on hold. During this period from June 2004 (the first Fed hike) to August of 2006 (the first Fed pause), the dollar was in a trading range, neither trending up nor down, a fact that surprised a market consensus going into 2005 that a dollar fall for that year was inevitable.

The fact that the dollar appreciated for most of 2005 illustrates that in a world of increasing global capital market integration, in which the dollar remains the global reserve currency, strong U.S. growth and rate hikes that keep U.S. inflation expectations anchored provide important support for the dollar. Also, the dollar still serves as a safe haven in periods of global economic and financial stress, as occurred in September 2001 and August 2007, to name just two examples.

Since the August 2006 meeting, at which the Fed announced at least a pause if not an end to the interest-rate hike cycle, the dollar downdraft has resumed. There are several reasons for this, and these reasons suggest the dollar downdraft is likely to continue for some time to come. First, the U.S. economy in the second half of 2006 slipped into what has now been more than a year of below-trend growth. Moreover, this occurred in the context of buoyant global growth, not only in the developing world, but also in Europe, Canada and Asia.

This relative U.S. underperformance is likely to continue, as the economy works through the headwinds of the housing contraction and consumer retrenchment in the face of tighter credit conditions and a soft labor market. But a U.S. recession is not necessarily in the cards, in large part because the Fed will probably ease more in future months to provide insurance against an economic contraction.

The U.S. economy will be moving toward a narrower trade deficit for some time to come. It appears as though the trade deficit has peaked, and it starting to decline as a result of slower U.S. growth, a robust global economy, and a weaker dollar. Indeed, all of the increase in the trade deficit between 2004 and 2006 was due to higher oil prices. The non-oil trade deficit has been more or less constant since 2004, and is now starting to show clear evidence of decline.
As the U.S. economy moves from being an engine of global growth to a path that is in line with the average of other major countries, the trade deficit will narrow and a weaker dollar will be part of that adjustment. This adjustment need not be inflationary.

Currencies can depreciate because of bad monetary policy, as was the case for the U.S. in the 1970s. But they can also depreciate with sound monetary policy if currency adjustment is called for -- as it is now -- to rebalance the domestic and global economies as the U.S. trade deficit shrinks.

The world financial system is undergoing an evolution, as economies from Asia to the Middle East to Europe allow more flexibility in their exchange rates and/or peg them against a basket of currencies and not just the dollar.

Reserve diversification will continue, and sovereign wealth funds will likely invest across a broader range of assets than reserve managers do at present. All of these developments will keep the dollar downdraft going for some time.

A U.S. inflation surge is not likely, although the Fed will face upward pressures on inflation from sources that were not so prominent until recent years -- a possible slowdown in productivity growth and booming commodity prices, as well as the weaker dollar.

But ultimately the U.S. inflation rate will be up to the Fed. At present, with core inflation measures within the Fed comfort zone, and payrolls contracting, the Fed is now rightly focused on cutting interest rates to preempt a U.S. recession.

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