Since August 1995, the strong-dollar policy has consisted exclusively of periodic statements by government officials — mainly the Secretary of the Treasury, occasionally the Chairman of the Fed — insisting that the US continues to pursue a strong-dollar policy (Klein 2011). While not all Treasury Secretaries have explicitly advocated a strong dollar (notably Treasury Secretaries Paul O’Neill and John Snow), current Treasury Secretary Timothy Geithner has repeatedly affirmed his support.
The strong-dollar rhetoric contrasts with a weak-dollar reality (Buiter and Rahbari 2011). From their peaks early in 2002, the broad nominal effective exchange rate fell by 25.1% and the broad real effective exchange rate by 26.7% (Figure 1). There has also been an almost complete absence of any policy measures to support the dollar. The rationale behind the strong-dollar policy is to prevent a rise in the yields on US Treasuries and many related assets and to deflect potential allegations of ‘competitive depreciation’, while there are net trade benefits from a weak dollar. The strong-dollar policy thus relies on misguided foreign-exchange market participants or on ‘benign neglect’ — benign neglect of the actions or statements of US policymakers, that is. Either way, we think the continuation of the strong-dollar policy and weak-dollar reality damages the reputational capital of the Treasury and the Fed and reduces their ability to influence markets by using statements of intent or announcements, but is nevertheless unlikely to disappear anytime soon.
Figure 1. Dollar nominal and real effective exchange rates, Jan 2002-Apr 2011 (Jan 2002 = 100)
Note: 1 — Nominal trade-weighted exchange value of dollar vs. major currencies; 2 — real trade-weighted exchange value of dollar vs. major currencies; 3 — nominal broad trade-weighted exchange value of the dollar; 4 — real broad trade-weighted exchange value of the dollar. Sources: Federal Reserve Board and CIRA.
The politics and economics of the strong-dollar policy and the weak-dollar reality
The desire of senior US policymakers to prevent a sharp decline in the dollar or collapse in its external value is motivated by the recognition that a sudden weakening of the dollar (or the market’s belief in a sudden weakening of the dollar) would likely be associated with a sharp rise in long-term US Treasury yields and of the many important public and private interest rates that co-move with them.A lower dollar reduces the local currency return on dollar investments for foreign investors and should call forth an increase in the yield required for foreign investors to hold on, let alone add, to their holdings of Treasury securities. Foreign ownership of US government securities has risen strongly over the past decade and has been above 50% of the total since 2004 (Figure 2).1 Additional concerns about the external value of the dollar may be generated by the dollar’s reserve currency status and, in principle, about foreign-currency exposure of the US banking system – in practice, the liabilities of the US banking system are mostly in dollars.
Figure 2. Foreign-owned marketable US Treasury holdings
Sources: Bureau of the Public Debt, Table 1, Summary of Public Debt Summary of Treasury Securities Outstanding, Total marketable held by the public less Bills, and CIRA.
By contrast, a low actual dollar exchange rate may be seen as a net benefit for the US, because, in the presence of nominal rigidities, a depreciation of the nominal dollar exchange rate implies a real depreciation and therefore an increase in the international competitiveness of the US tradables sectors. The US is quite an open economy today, with the ratio of trade (the sum of imports and exports) to GDP at around 30%, comparable to Japan (Figure 3). Net exports have also played a significant part in the slowly solidifying recent cyclical recovery in the US, though it is, of course, true that many factors affect the evolution of net exports besides the level of the (nominal or real) exchange rate.
Figure 3. US and Japan — Trade openness (% of GDP), 1970-2010
Note: Exports plus imports of goods and services, % of GDP. Sources: Census Bureau, Bank of Japan/Ministry of Finance and CIRA
An improvement in the international competitiveness of the US tradables sectors is equivalent to a deterioration in the competitiveness of the trading partners of the US. It is therefore no surprise that a weak dollar can lead to irritations in the corridors of international diplomacy. Two additional factors come into play currently. The first is that the US has long upheld the view that the very slow appreciation of the renminbi vis-à-vis the dollar results in an undervalued renminbi that puts the US at a competitive disadvantage. Any moral high ground the US can occupy in this dispute is eroded if the US is seen to engage in a form of market-mediated downward adjustment of the dollar exchange rate. The second is that the US position in the ‘currency wars’ debate – a debate about the potentially negative effects of highly permissive monetary and liquidity policies in advanced economies on emerging markets – would undoubtedly be weakened if it became widely accepted that the expansionary monetary policies pursued by the US since 2008 would inevitably entail a weakening of the dollar.
Exchange rate determination and the (ir)relevance of intent
A bilateral nominal exchange rate is the relative price of two moneys, strictly speaking, of two currencies or base monies. All drivers of money demand and money supply, at home and abroad, are therefore relevant to the determination of the nominal exchange rate.A large number of factors can influence the dollar exchange rate when this exchange rate is market-determined and floats more or less cleanly. Yet when all is said and done, we cannot think of any model of the monetary transmission mechanism in an open economy with a floating (market-determined) exchange rate for which the proposition fails to hold that expansionary monetary policy will, ceteris paribus, weaken the exchange rate. This holds true when the official policy rate of the monetary authority is above the effective lower bound on nominal interest rates and when policy rates are at the lower bound and the central bank engages in large scale asset purchases, in the latter case due to the presence of irreducible financial market inefficiencies.
With the exception of a tiny operation with the Bank of Japan, the ECB, the Bank of Canada and the Bank of England in March 2011 to prevent excessive yen appreciation following the Japan earthquake, US authorities have not intervened a single time since 2000, in sharp contrast to the first quarter century since the collapse of the Bretton Woods regime in 1973 when intervention was quite frequent. Monetary policy has been unqualifiedly expansionary since the onset of the financial crisis (expansionary not only in relation to earlier US monetary policy, but also relative to the monetary policies pursued by the other leading central banks).
The exchange-rate consequences of this policy, significant and predictable as they are, nevertheless scarcely receive mention in statements and speeches of Fed officials. One reason is an institutional anomaly which is not unique to the US, namely that, although monetary policy constitutes the single most important type of policy affecting exchange rates, ultimate authority over the management of the exchange rate rests with the Treasury, not the Fed. Another reason for the omission of discussion of the exchange rate in Fed documents may be a legacy from the now bygone days when closed-economy thinking was less inappropriate.
Yet another reason for the lack of discussion may be the view that because the dollar is freely floating and its value is thus set by market participants or by ‘the market’, unlike the currencies of countries with managed exchange rates, its value is not manipulated in any view. This argument holds little merit as expansionary monetary policy can be expected to depreciate the currency even if depreciation is not desired, sought or intended by the policymaker.
Conclusion and outlook
The US strong-dollar rhetoric has contrasted sharply with a weak dollar reality — which is not surprising given the almost complete absence of any policy measures to support the strong-dollar policy and, especially since the financial crisis, a consistently expansionary monetary policy with predictable (depreciative) exchange-rate consequences. By one measure, the strong-dollar policy has been a success. Treasury yields remain close to all-time lows despite persistent depreciation of the dollar, a very large (federal and general) government budget deficit, and high and rising (federal and general) government debt. The downside, however, of talking a strong-dollar talk while walking a weak-dollar walk has been damage to the reputational capital of the US monetary and fiscal authorities and thus a reduction in their ability to use statements of intent or announcements of future policy actions to influence markets.In any case, we see little immediate prospect for either the strong-dollar rhetoric or the weak-dollar reality to disappear anytime soon. High and rising levels of general government debt mean the Treasury will keep a close eye on Treasury yields. The need for rebalancing in the US economy suggests continuing loose monetary policy, while the eventual fiscal tightening, if and when it happens, will put further downward pressure on the dollar. The alternative scenario – a fiscal crisis in the US – will also likely be associated with a dollar weakening, of a more dramatic kind. But even a dramatic fall in the dollar and/or a marked rise in Treasury yields would not mark the end to the primacy of the dollar as an international currency just yet – for that, a viable alternative was needed, and for the time being none is in sight."
