The effects of Federal Reserve and other central banks’ policies on exchange rates are back in the news. A Bloomberg News headline, “Currency wars evolve with goal of avoiding deflation,” is typical. This implies that changing the value of our currency, relative to other nations, is driving monetary policy. But is this really the case? Are we really in currency “wars?”
Several readers have asked that. The answer is yes and no.
That sounds like waffling, but it reflects the reality that effects of monetary policy on exchange rates vary greatly between countries. It is a dangerous error to generalize.
First, let’s review the basics of exchange rate changes.
When a currency, say the euro or yen, becomes less expensive relative to the U.S. dollar, or “weaker” in common but misleading terms, each dollar buys more of these other currencies.
Thus it takes more euros or yen to buy a U.S.-exported computer router, bushel of corn or heart valve. The higher price means fewer units are bought, hurting U.S. exports.
This also means that buying a German or Japanese car, an Airbus jetliner, French cheese or Italian ham takes fewer dollars. More gets bought here. And because imported goods are cheaper, U.S. producers find it harder to raise prices. This is good for consumers.
Any U.S. farm or firm that produces goods for export, and/or competes with imports on price, has tighter margins and lower profits. They employ fewer workers. So businesses suffer from a “strong” dollar, as does labor.
The reverse happens when the dollar loses value relative to other countries. One U.S. dollar buys fewer imported goods, so we import less. Prices of goods in this country are more apt to rise. Exports increase and, thus, so do profits in business and agriculture. Employment rises. Consumers are worse off, but producers and workers benefit.
Every U.S. presidential administration says it is following a “strong dollar policy.” Implicitly, they are saying “we favor higher consumption over more production and greater employment.”
But there is precious little any president or Congress can do to raise the value of the dollar. That’s the Federal Reserve’s job.
When the Fed constrains the money supply and raises interest rates, the United States becomes a better investment. Capital flows in. Since you need dollars to buy a U.S. bond or share of stock, their value is bid up. The dollar becomes “stronger.”
Conversely, cutting interest rates as the Fed has done reduces investment yields and makes our country less attractive to foreign investment. Demand for the dollar drops, and its price falls. It becomes “weaker.”
There are other interactions, but these are the most direct.
In many large, wealthy countries, but especially ours, the exchange rate is seldom the primary variable for monetary policy makers. They lower interest rates to foster faster growth, as in 2001 and 2008. They raise them to curb inflation, as in 1979. The primary concern is the effect of looser or tighter money on output and employment. What changes do to the exchange value of the dollar is secondary.
As central banks around the world pumped up their nations’ money supplies as a financial debacle unfolded in 2008, the values of the currencies of those that acted first and most drastically fell relative to the values of other that started later and did less. Thus the values of the dollar, euro, pound and yen fell relative to the money of developing countries, such as Brazil.
That disadvantaged such countries. Brazilian soybeans became less competitive with U.S. ones to European and Asian buyers, as did its steel and myriad other products. Its finance minister complained that big nations were waging a “currency war” in which the smaller countries were decimated by stray bullets as their exports shrank and imports rose. They could have fought fire with fire by increasing their own money supplies, but, for a variety of reasons, they faced more immediate inflation as a result.
Was the finance minister right? As in personal injuries, intent was a key issue. Was the weakening of rich country currencies deliberate or “accidental?” That question remains today.
One explanation is that the degree of intent varies directly with the importance of trade to the nation’s economy. International trade is important to our country but in relative terms not as much as to Europe and much less than to Japan, China and many other Asian nations.
The dramatic Fed boost of bank reserves in 2008-10 was a desperate measure to keep the financial system from imploding and the broader economy from sliding into depression. If this also increased U.S. exports of corn and pacemakers, so much the better for profits and employment. But these considerations didn’t head FOMC considerations.
The European Central Bank acted more slowly and meagerly, as did the Bank of Japan, which faced less danger to its banking system. But money became more available nearly everywhere and interest rates fell around the globe.
The Fed’s expansion was the most dramatic and, to date, the most successful. The U.S. economy is growing slowly, employment is rising, and the unemployment rate is falling. Compared with past experience, it is a halting recovery but compared with Europe and many other countries, we are doing well.
As the Fed acted more decisively than the ECB, the dollar lost value relative to the euro, as would be expected. But now with Europe’s economy teetering on the brink of recession and the Eurozone near deflation, the dollar is rising in value. It now costs 6 percent more on a “trade-weighted” basis against other currencies than it did at the beginning of the year.
That is bad for U.S. farmers and manufacturers and is negative for job growth. But should the Fed pay attention to this going forward?
The classic tradeoff for any central bank is balancing the risks of inflation versus recession. In normal times, if you increase the money supply too fast, you will foster inflation. Increase it too slowly and you get stagnation.
The fact that inflation in goods and services remains muted gives the Fed breathing space. It also induces hubris, with the central bank announcing months and years in advance what it will do. But the best-laid plans of mice and banks oft go awry.
The situation in Europe is more serious that most Americans understand. Divisions between Eurozone countries on economic policy remain deep. But count on the ECB doing whatever it can to fend off deflation. That means monetary expansion and a still weaker euro. At the same time, Japan tries hard to weaken the yen to stimulate its own flagging economy. All that bodes ill for U.S. manufacturers and farmers.