The Falling Dollar

Richard DeKaser

The U.S. dollar decline that began five years ago has recently picked-up pace. Factors driving the accelerated slide are myriad, but notably include lower interest rates and uncertainties surrounding the performance of residential mortgages. Calling this development a categorically bad one, however — as the term “dollar weakness” connotes — is wholly inappropriate.

To be sure, there is a downside to the weak greenback, namely inflation. Because most commodities are traded around the world in dollars, the depreciating U.S. currency translates into reduced purchasing power for commodity producers. Simply put, the dollar just doesn’t buy what it used to, so commodity producers have every incentive to recapture some of their product’s lost value by raising prices.

At the same time, the falling dollar partially insulates those in other nations (aside from those that peg their currency to the dollar), from the full brunt of rising commodity prices. For example, the price of crude oil to Americans increased 60 percent in the past year, but residents of the Euro Zone experienced a 46 percent increase as its appreciating currency shaved 14 percent off the dollar-based price. Hence, global demand is unlikely to suffer enough to fully reverse the buoyancy of prices.

More generally, a declining dollar directly makes imports — which now account for a record 17 percent of GDP — more expensive. While some of these imports have no direct domestic competitors (bananas, for example), most do (think cars). And the higher price of imported goods provides domestic producers with greater latitude to increase their own prices.

Collectively, these currency related inflationary pressures constrain the Federal Reserve’s ability to reduce interest rates. Because lower interest rates are a major determinant of a weaker currency, any rate cuts will tend to exacerbate inflationary woes.

But there’s more to a depreciating currency than higher inflation and a boxed-in monetary policy. The flip side of more expensive imports is less expensive exports, at least to those paying with stronger currencies. So the global competitiveness of U.S. exporters, especially manufacturers, is greatly enhanced.

Between 1999 and 2005, for example, the lofty dollar contributed to ever larger trade deficits, directly translating into an average drag on economic growth of roughly 0.5 percent each year. But the dollar’s decline has helped turn that around. The trade gap that peaked in 2005 has fallen steadily since, and foreign trade has directly added nearly a full percentage point to economic growth in the past year — almost completely offsetting the drag resulting from the housing sector implosion.

Moreover, there’s every reason to expect the weaker dollar to boost foreign trade even more going forward. You see, importers and exporters are often bound by sales agreements in the short-term, and often hedge the risk of currency movements with various types of derivates. They also may sacrifice profit margins, for a while, in the interest of preserving market share. But the farther the dollar declines, and the longer it persists, these short-term palliatives gradually diminish. And its 22 percent drop over more than five years implies that the full impact of the dollar’s descent has yet to be fully felt.


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