The relentless rise of the dollar during January and February finally drove the major central banks of the world to a burst of coordinated intervention aimed at lowering the dollar's value. During the last week of February, those central banks sold $3 billion in exchange for German marks, British pounds and other currencies. The result was a sharp but temporary fall of the dollar. Within days the foreign exchange markets had easily absorbed the $3 billion, and the dollar's value was again on the rise.
This experience confirmed that the dollar is still being supported by the same fundamental forces that have already caused it to rise by nearly 70 percent relative to other foreign currencies since 1980. That means that the dollar buys on average nearly 70 percent more foreign- made goods in comparison to American made goods than it did at its low point in 1980. With the British pound down to less than $1.10, the dollar buys almost twice as much in British goods as it did in 1980. It's not surprising therefore that U.S. imports of foreign products outstripped our exports to the rest of the world last year by more than $100 billion.
The dramatic rise in the dollar has happened in the past four years as the United States became the world magnet for financial investors. Here foreign investors unload their currencies to buy dollars to invest in U.S. securities or to deposit with American banks. Foreign private assets in the United States have more than tripled since 1978, increasing by nearly half a trillion dollars. In addition, American banks and other investors have recently cut back on overseas investments to concentrate on investments at home. This desire of foreigners and Americans to invest in the United States has been the force driving the dollar to new highs.
Both foreign and American investors are attracted to U.S. investments by the higher real interest rates and the greater safety of investments in the United States. The real return on investments is higher here both relative to our own past yields and to present yields in other countries.
In the 1970s, short-term investments earned just about enough interest to keep up with inflaton. Now those short-term investments earn nearly five percentge points more than the inflation rate, and investments with longer maturities earn substantially more. The rise in U.S. real interest rates has also greatly exceeded the interest rate rise in other major countries. For example, although Germany has an inflation rate similar to that in the United States, interest rates there are three to five percentage points lower than in the United States, depending on maturity.
The principal reason for the increase in U.S. real interest rates has been the rise in the budget deficit. Government borrowing to finance the deficit now absorbs more than half of all net savings in this country. The increase in the government's annual demand for the funds -- from $50 billion in 1980 to more than $200 billion this year -- far outweighs the secondary increase in demand for investment funds by the U.S. firms experiencing improved investment incentive resulting from lower inflation and from the 1981 revisions in business taxation. The increased demand for funds raises the real interest rate and leads in turn to the strong dollar.
Careful followers of the financial markets may be puzzled that the dollar has continued to rise in recent months despite the fall in interest rates since last summer. The principal reason for the dollar's seemingly paradoxical behavior is that the interest rate decline has been primarily a reflection of lower expected inflation rather than a lower real yield. Expected inflation has declined since last summer for two reasons: the economy's slowdown has sharply reduced the fear of overheating and the favorable inflation experience has refuted the monetarists' predictions of a return to double-digit inflation by the end of 1984. In addition, the dollar appears to have been strengthened in recent months by the sharp turnaround in overseas lending by U.S. banks.
Although the overstrong dollar has had a devastating effect on U.S. exporters and firms that compete with foreign imports, the rise in the dollar has also had some good effects on the American economy. The inflow of foreign funds will be enough this year to finance half of the government deficit or some 40 percent of all net investment in housing and in plant and equipment. Thus it has helped postpone the adverse investment effects of the enormous federal deficit. In addition, the rising dollar has reduced inflation by lowering the cost of imported consumer goods and creating competitive pressures that lower domestic prices and wages.
But what of the future? The dollar must eventually fall. The dollar's abnormal strength depends on a continued higher real yield on U.S. investments, on the expectation that that yield differential will last, and on the continued willingness of foreign investors to take the risk of holding dollar securities. At some point, possibly as long as several years from now, foreigners are going to be reluctant to continue putting a larger and larger share of their portfolios in dollar securities. The increasing risk will outweigh the yield difference.
When the dollar falls, the higher prices of imported goods will put upward pressure on prices and wages in the United States. Past experience suggests that a 10 percent fall in the dollar leads to a 1 to 11/2 percent rise in consumer prices after a lag of about 18 months. Without the rising dollar in the past few years, the current 4 percent inflation would have been more like 5 percent. But that means that when the dollar falls, the upward pressure on prices could temporarily raise the inflation rate to 6 percent or more.
A tough monetary policy in response to a falling dollar could avoid the increase in inflation, but only at the cost of slowing the growth of economic activity. If the dollar falls very rapidly, we might find ourselves back in the same slow- growth-high-inflation corner we were in in the 1970s. Even if the dollar comes down gradually enough to avoid that problem, it's a fairly safe bet that the United States will experience a temporary hump in inflation as the dollar falls sometime before this decade is over.
The lower dollar will also mean a smaller inflow of capital from abroad and therefore less money available to finance borrowing in the United States. If the dollar falls substantially before a resolution of the budget deficit, we will face sharply higher interest rates and a sharp contraction of investment in housing and in plant and equipment. That'swhy we continue to hope that Congress and the administration will get together to deal with the budget deficit before it's too late.