Understanding the Falling Dollar

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Council on Foreign Relations
Monday, November 12, 2007; 4:07 PM

Brad W. Setser, CFR's fellow for geoeconomics and an expert on currencies, outlines the factors leading to the precipitous recent fall in the valuation of the U.S. dollar.

Setser says expectations that the U.S. Federal Reserve will make further rate cuts have added to the dollar's decline, and says more generally that some countries with large dollar reserves are becoming less comfortable sitting on these reserves. He says the Fed shouldn't attempt to use interest rates to sway currency exchange rates, but should focus instead on guaranteeing domestic economic stability, adding that it would take a "rather extraordinary series of events" to create a situation in which the United States ought to intervene directly in currency markets by coordinating the sale of euros or yen and buying dollars.

The dollar has fallen quite fast in recent weeks. Last week it hit record lows against the euro and it's now trading below the value of the Canadian dollar. Why is this happening now?

Well, there are a few reasons. One is that the subprime crisis of the summer shook the world's confidence in certain kinds of U.S. financial assets--particularly the more complicated, so-called structured products, derivatives based on housing-market debt. And as the private demand for U.S. debt fell, that correspondingly had an impact on the dollar. If the attractiveness of the financial assets your economy is generating falls, and there's no increase in the attractiveness of other kinds of assets, the net effect is that there's less demand for your assets and your currency.

I think more importantly, the credit crunch of the summer--or the possibility that the difficulties in U.S. credit markets might lead to a credit crunch and a meaningful economic slowdown--have changed the market's expectations about the likely path of the Federal Reserve. The Federal Reserve first cut rates by fifty basis points, then cut again, and the market expects further cuts in the Fed's policy rates. So the interest rate differential, or the fact that U.S. interest rates were higher than European rates, is no longer the case. And as U.S. interest rates have fallen, the attractiveness of holding the dollar, relative to the euro, has gone down.

Finally, my best guess is that several oil exporters are a bit less willing to hold on to dollars than they used to be, and that's an additional source of pressure on the dollar.

How much power do governments have to control the value of their currency internationally?

There are two components to that. One is what sort of power does the U.S. government have, and by that I specifically mean the U.S. Federal Reserve. Most people believe that short-term interest rates do have a meaningful impact on the relative value of different currencies. So monetary policy can be used to defend a country's currency. The real question there is should it be used to defend a country's currency, or should monetary policy be directed at domestic objectives. Certainly most economists' views, and I share that view, is that the core goal of U.S. monetary policy should be stabilizing U.S. domestic conditions, not trying to stabilize the value of the dollar. So the policy tool the U.S. has that most obviously would impact the value of the dollar right now is not used to stabilize the exchange rate, it's used to stabilize domestic conditions in the U.S. And given that right now domestic conditions in the U.S. are such that policy interest rates have come down, that's actually working against the dollar.

Then I think on the other side, the dollar is being supported, even now, by the resistance in many Asian economies--not just Asia, also many emerging economies around the world--to any strong increase in the value of their currencies against the value of the dollar. And by intervening to hold their currencies down, they are in effect holding the dollar up, not necessarily against the euro but against their own currencies. So I certainly think that has an impact.

Is there any situation in which you think U.S. intervention to stabilize the dollar would be appropriate?

We have to differentiate between a decision on the part of the Fed to direct its monetary policy toward supporting the dollar, which I don't think would be appropriate. It's also not really consistent with the Fed's mandate. But I do think it's appropriate for the Fed to consider how a weak dollar might impact its ability to achieve its domestic goals--including the goal of price stability--which provides a context in which the Federal Reserve might be less willing than it otherwise would be to reduce U.S. policy rates because of concerns that a falling dollar might feed higher inflation. I think that's a legitimate consideration for policy.

Then a second mechanism would be direct intervention in the foreign exchange market. That's something that other countries do rather regularly, but the U.S. has not done on a consistent basis for a long time, and the Bush administration hasn't done at all. And I certainly think that's a tool that shouldn't be ruled out, though I think it would take a rather extraordinary series of events in order for it to be used.

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