Politics & Policy

Saber-Rattling Time

The Treasury and Fed can team up for the dollar.

If the U.S. government is serious about a “strong dollar” policy to stop the daily greenback decline on foreign exchanges, there are two saber-rattling moves that can be taken right now.

At one and the same time, the Federal Reserve can remove its “considerable period” lifetime guarantee of a 1 percent fed funds policy rate and the Treasury can establish a new two-sided market by intervening to buy dollars and sell euros.

These two moves would send a shot across the bow to foreign-exchange traders, all of whom are short dollars and are playing the momentum-trade against the U.S. currency.

Nothing fundamental would change in terms of monetary policy; the flow of bank reserves created by the Fed would remain supportive of the Bush tax cuts and the prospering U.S. economic recovery. A well-timed Treasury intervention would be nothing more than a market signal. But signals do matter.

The financial headlines are all obsessing about the so-called weak dollar — but they shouldn’t be. U.S. stocks have had a great year and government bonds are steady. The economy is surging above expectations.

So is the falling dollar really a bad thing? Right now the answer is no.

The euro’s value was way too low when it was worth only 84 cents in the middle of 2001. The original public offering of the euro came at the start of 1999 at slightly less than $1.20. Now it’s back to $1.22 — a round trip. The yen, meanwhile, has strengthened about 20 percent over the past two years.

Supply-side mentor Art Laffer attributes the swing in currency values to changes in real capital returns among the euro, the yen, and the dollar. When inflation-adjusted Treasury rates surged above 4 percent at the height of the last economic boom, the dollar overshot way too high on the upside. Tight money from the Fed contributed to this currency overshoot.

Today’s real Treasury rate (as a proxy for U.S. real investment returns) is around 2 percent. That’s still respectable but it’s way below the prior peak. As the nascent business recovery gathers steam here at home, the real rate will probably rise to about 3 percent over the next year or so.

Meanwhile, economic policies in Japan and Europe appear to be improving, at least somewhat. Koizumi is deregulating in Japan, and Chirac and Schroeder are trying to lower taxes and deregulate in Europe. Jean Claude Trichet, the new head of the European Central Bank, is thought to be much more capable than his predecessor Wim Duisenberg, who didn’t care about the euro’s value.

The essential point to remember in all of this is that currency swings are mirroring growth policies and real capital returns among the big three economies. In addition, the terms of trade are improving for the long-depressed European and Japanese economies. All this suggests that the dollar and its economy are not tanking, and that our foreign counterparts are getting better.

Laffer believes that the shift in real exchange rates will sharply lower the current-account trade deficit in the U.S. from nearly 5 percent today to roughly 2 percent in the next few years. This would be a highly constructive development for world economic stability.

There are no serious inflationary consequences to the world currency adjustment process. Core import prices in the U.S. are only 0.7 percent over the past year. Consumer prices are just slightly above 1 percent, and wholesale prices are about flat. Business hard-good prices have actually fallen 3 percent. Lower tax rates, rising productivity, and faster growth are all counter-inflationary.

Raw material commodity indexes have reflated in response to easier money from the Fed. But much of the recent commodity rise is a function of booming Chinese production and a shortage in many commodity areas. At the same time, soaring Baltic freight rates and inadequate shipping-cargo space have intensified the commodity price rise. But these are one-time events, not recurring inflationary developments.

As the dollar has declined, gold has jumped to slightly over $400. But just as the former has sold off too much, the latter has risen too far. However, U.S. policymakers should want to avoid another 20 percent move in the dollar and gold. That might tempt inflationary forces that could undermine America’s strong economic recovery.

Every now and then central banks and finance ministries can take limited steps to reinforce policy goals and promote two-sided markets. Traders have gotten way ahead of themselves by constantly shorting dollars and buying gold. This trade should not be a sure thing.

Now would be a good time for the Fed and the Treasury, perhaps working with their G-7 counterparts, to signal world markets that the currency adjustment has gone far enough. If they do so, foreign exchange markets will have a bid and an offer for dollars, yen, and euros.

Members of the National Review editorial and operational teams are included under the umbrella “NR Staff.”


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