Pundits and policymakers around the world are wringing their hands over the possibility of further declines in the foreign exchange value of the dollar. Predicting exchange rates is notoriously difficult; there is almost as much chance of the dollar rising next year as of it declining. But if the dollar were to fall further, should we be concerned?
A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers. However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies. Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.
The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries. The correct response is to ease monetary policy and temporarily delay fiscal contraction. As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.
For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery. The fear is that a falling dollar would be inflationary. However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level. With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term. Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar). Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it. Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.
For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma: how fast to tighten macroeconomic policy as the economy recovers? These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation. These differences will determine the appropriate policy stance. To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs. In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.
By Joseph E. Gagnon
Originally published at The Baseline Scenario and reproduced here with the author’s permission.