The good news, if you're planning on taking a trip abroad, is that the dollar is on a tear. But the bad news, if you're planning on working in the U.S., is that, well, the dollar is on a tear.
In the last six months, as you can see above, the dollar is up 12 percent, on a trade-weighted basis, against a broad index of currencies. That's made it an opportune time to take, say, that European vacation you've been thinking about, but maybe couldn't afford when the euro was worth $1.45 instead of the $1.13 it is now. But it's also made our exports more expensive for everybody else and our imports cheaper for us, both of which hurt demand for the things Americans make. That's already widening the trade deficit—how much more we buy from abroad than sell abroad—and dragging down economic growth.
Now trade is the most volatile part of GDP. It just depends on so much: how our economy is doing, how everybody else's are, and people's tastes. But most of all it depends on the exchange rate. When the dollar is worth more, it's like our imports are being subsidized and our exports are being taxed. So if it goes up too much, our manufacturers will have a harder time competing against foreign companies at home and abroad. That alone wouldn't turn our mini-boom to a bust, but it would make it even more mini. Car companies, for example, would either have to lay people off or not hire people like they otherwise would have, which would ripple through the rest of the economy as there was less money for people to spend overall. The virtuous circle, in other words, would get a little less so.
And it's only going to continue.
The simple story behind this is that the stronger your economy, the stronger your currency. But the slightly more complicated version is that currencies go up when monetary policy is tight, and down when it's loose. That's trickier than it sounds, though, since central banks can make mistakes and tighten policy—hello, Europe—when the economy is weak, or mistake zero interest rates for easy policy—hello, Japan—when the economy needs even more help than that.
The problem is that the U.S. is one of the few places where monetary policy is about to get tighter, not looser. That's because the economy is doing well enough, with its best job growth since 1999, for the Federal Reserve to finish winding down its bond-buying program last October and get ready to start raising rates as soon as this June. So the dollar, in other words, is strong because the U.S. economy is strong, and it's about to get even stronger because the Fed is about to start tightening even more. Well, that and the fact that the rest of the world is slowing down.
Just think about this. In the last five months, Egypt has cut interest rates to 8.75 percent, India to 7.75 percent, Indonesia to 7.5 percent, Turkey to 7.5 percent, Peru to 3.25 percent, Chile to 3 percent, Australia to 2.25 percent, Poland to 2 percent, Canada to 0.75 percent, Israel to 0.1 percent, Sweden to -0.1 percent, Switzerland to -o.75 percent, and Denmark to -0.75 percent. Meanwhile, the eurozone has started buying bonds with newly-printed money, and Japan has started doing even more of the same. Even China, whose currency is pegged, with a little leeway, to the dollar, has eased policy. So has Singapore. And with global growth still floundering, there should be plenty more rate cuts to come.
This combination of higher expected rates in the U.S. and lower rates everywhere else is what's pushing the dollar up. That sounds nice—strong dollars for a strong America—but it's actually a bit of a problem. And it's more of one than usual. Think about it like this. It might not be a boom, but this is the closest the U.S. economy has been to one in quite awhile. Lower unemployment, lower household debt, and lower oil prices, not to mention the end of austerity, have all pushed the recovery into a higher gear. Now, if the rest of the world—Europe, in particular—looked like it was going to keep, or at least catch, up, then the dollar wouldn't go up that much. But Europe probably won't be able to manage either anytime soon. That's why, as Paul Krugman explains, the dollar is shooting up rather than edging up. Who wants to hold their money in euros that might not pay any interest for years when you hold it in dollars that might soon?
What's the Fed to do? Well, it could continue on its plan to raise rates because of low-ish unemployment, and risk killing whatever momentum the recovery has with a strong dollar. Or it could keep rates at zero because of the strong dollar, and risk ... well, it's not clear what. Not inflation. Overall prices are up an anemic 0.7 percent the past year, core prices just 1.3 percent, and wages are stuck at 2.2 percent. And not a bubble. Household debt ratios are still falling, and while subprime auto loans are worth watching, that's still a tiny market at only $20 billion.
No, the real risk is raising rates too soon, just because it seems like we should, even though wages and inflation are quiescent. That's the mistake Sweden made in 2010, when it hiked rates from zero to 2 percent, because it convinced itself that a potential bubble was a bigger problem than its actual recovery. To make up for that, it's had to cut rates even lower than before, to -0.1 percent, and begin buying bonds.
For the first time in a long time, the economy's growth looks strong and sustainable. The only thing that can stop it is if we make our exports uncompetitive and our imports too competitive. In other words, if we let the dollar get too strong. That would turn our 2.5 to 3 percent growth into 1.5 to 2 percent — and leave the shadow unemployed on the sidelines forever. That's too high a price to pay for a cheap trip to Europe.
Paris isn't worth a mass of unemployed workers.