Tuesday, September 29, 2009

The Sliding Dollar...

On two separate occasions in the last several days, the ECB President, Jean-Claude Trichet, has emphasized- with some uncharacteristically for him vigorous language- the need for a strong dollar.

(http://www.ecb.int/press/key/date/2009/html/sp09092) (http://www.bloomberg.com/apps/news?pid=20601087&sid=aSd5pt2tYX.o)

The dollar has declined by about 15% against the euro since February, while it is within striking distance from its 13-year low against the yen. On a trade-weighted basis, the U.S. currency has lost approximately 11% of its value during that period.

The dollar's erosion per se may not be particularly dramatic, as it has taken place under overall orderly foreign exchange market conditions. However, it has certainly been sizable enough to raise concerns both in the Eurozone countries and Japan about its adverse implications for their own fledgling economic recoveries, as the sharp rise of their respective currencies against the dollar is now shaping as a significant headwind for the price-competitiveness of their exports at a critical juncture of the business cycle.

The dollar's slide itself can be mostly attributed to slowly building uneasiness that it may gradually lose its longstanding status as the key reserve currency around the world as well as concerns over the strength and sustainability of the U. S economic recovery underway. In the process, as is so often the case in the emotion-driven foreign exchange markets, an overall sour mood vis-a-vis the U.S currency seems to have slowly taken hold.

So, Mr. Trichet's apparent anxiety of late over the dollar decline and his repeated comments highlighting the importance of a strong U.S. currency are understandable. The trouble is that there is not much he can do about it, other than making more comments in the same vein.

The Fed has a well-known, although unspoken, policy of not allowing considerations about the dollar drive monetary policy decisions. This approach is based two main reasons: a) The fundamental incompatibility of having both an exchange rate and interest rate target at the same time- and the Fed, over the last three decades or so, has clearly thrown its lot behind interest rate targeting. b) The fact that the external sector of the U.S. economy is still relatively small (12% to 14% of GDP) and, therefore, changes in the value of the dollar are unlikely to be the determinant factors for either the pace of economic growth (via the exports mechanism) 0r the inflation prospects.

So, it is beyond unimaginable that, in this setting, monetary policymakers would be inclined to change tack and focus on the sliding dollar by raising short-term rates to defend it. To make things even more hopeless for Mr. Trichet, the U.S. Treasury also has a longstanding policy of not intervening in the foreign exchange markets (in conjunction with the New York Fed) but only in exceptional circumstances to counter disorderly market conditions. The 8-month slide of the dollar most certainly does not meet that criterion.

The only consolation that the Fed and U.S. Treasury can offer to address Mr. Trichet's plight is, at the most, to make generic, devoid of much substance, statements to the effect that the U.S. is in favor of a strong dollar. Lip-service on this issue is an inexpensive but not terribly effective tool. Raising interest rates or engaging in massive intervention in the foreign exchange markets can be effective but they are beyond the realm of plausible outcomes for U.S. policymakers.

Given the nearly one-way path the dollar has been on since Fenruary and in view of the levels it has now reached, the more likely outcome is that a bottom will start being formed in the foreseeable future that will ultimately make this episode of dollar weakening look as just another run-of-the-mill "noisy" situation in the context of a floating exchange rate regime. There is no reason to believe that the dollar's decline will transform itself into an actual crisis.

In the last six years at the helm of the ECB, Mr. Trichet has shown himself to be is a highly competent and sophisticated central banker. Now, in view of the dollar decline so far this year, he needs to show that he can be patient too.