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The Good, The Bad And The Ugly About A Weaker Dollar

Tue, Sep 25 2007, 08:41 GMT
by Wachovia Corp. Economics Group

Wachovia

U.S. Review

The Good, The Bad And The Ugly About A Weaker Dollar

We are constantly asked whether a weaker dollar is good or bad for the U.S. economy. There is no one simple correct answer to that question. A lower dollar makes U.S. exports more competitive versus European and Japanese producers. As a result, U.S. exports strengthen and imports grow less rapidly. Foreign direct investment into the U.S. also increases. All of this is good, but it would be far better if it occurred without cheapening the U.S. dollar.

While a lower dollar improves U.S. competitiveness, the gains typically are fleeting. The lower dollar did not fix whatever caused these firms to be uncompetitive in the first place, such as low productivity or high health care cost. In order to remain competitive, the dollar would need to go lower and lower.

A much better and more lasting way of boosting competitiveness is through productivity gains, which require investment in human and physical capital. A weaker dollar does not help on this front. In fact it may inhibit it, as the weaker dollar provides the short-term illusion of boosting competitiveness.

A Fistful Of Dollars

The ugly part of a weaker dollar is what it does to prices of imported goods. Like it or not, U.S. consumers have become accustomed to lower-priced imports. Imported automobiles, laptop computers, flat panel televisions, and toys of all types remain in high demand. A weaker dollar, particularly against the Japanese Yen, Korean Won, and Chinese RMB means that prices for all of these items will either increase are stop falling as rapidly as they had been in the case of high tech items. Prices of Chinese-made goods actually increased this past month, rising 0.3 percent. With prices of imports rising, the days of cheap imports may be ending and consumers might soon find it takes a fistful of dollars to afford all those flat screen televisions, video games, and computers they are so fond of.

Clint Eastwood might just be able play the part of Alan Greenspan in the movie version of The Age of Turbulence. The Greenspan book and all the interviews surrounding its release on Monday helped set the stage for Tuesday’s FOMC meeting. The Bernanke Fed surprised the financial markets by cutting the federal funds rate by a half percentage point instead of the widely expected quarter percentage point.

The Fed’s decision to cut interest rates by a half percentage point is likely due to their growing concerns about the weakness in the housing market and in the mortgage and commercial paper markets. Their hope is that by cutting aggressively now that they will prevent the weakness in the housing and financial markets from spreading to other parts of the economy.

The inflation data also created an opportunity for the Fed. The Producer Price Index fell 1.4 percent in August and the Consumer Price Index Fell 0.1 percent. Both drops were largely tied to falling energy prices, which turned back up in September. Core inflation was not nearly as well behaved as the headline numbers, but did not present much of an obstacle either. We still feel the Fed has more work to do but are only looking for a quarter percentage point drop at the next FOMC meeting on October 31.

The other major economic reports released this week included a larger-than-expected drop in new home construction and building permits. We believe these numbers will head sharply lower during the fourth quarter but still expect home construction to bottom out around the middle of next year. The slowdown in home building has, so far, had only a minor impact on employment. First-time claims for unemployment insurance declined this past week and remain relatively low.

Global Review

Can You Say “Parity”?

In the wake of the Fed’s rate cut this week, the dollar depreciated against most currencies. Not only did the U.S. dollar fall to an all-time low against the euro but it also dropped against the Canadian dollar, falling to parity for the first time since December 1976 (see chart at left). If our forecast is correct, the greenback is destined for further depreciation against the loonie. (For details, see our “Monthly Economic Outlook”, which is posted at www.wachovia.com/economics.)

Why has the Canadian dollar strengthened over the past few years and why do we expect it to appreciate further? Let’s start with the former question. First, the U.S. dollar has depreciated versus most currencies over the past few years, and the loonie has simply followed that broader trend. However, there also are Canadian-specific factors at play as well. Canadian GDP has reaccelerated this year, leading the Bank of Canada (BoC) to raise rates in early July. Indeed, most investors looked for the BoC to tighten further until credit markets became dysfunctional.

In addition, the run-up in commodities prices over the past few years has helped to boost the Canadian dollar (see top chart). The Canadian economy is more dependent on production of natural resources than most other major economies, and rising commodities prices helps to boost the Canadian economy, which helps to keep Canadian trade accounts firmly in the black.

Canadian economic data lags U.S. economic data by almost a month, so it’s difficult to say exactly how the Canadian economy is doing at this moment. However, it appears to have had a good head of steam as the global credit crunch began to bite in late July. Manufacturing shipments in July rose 2.3 percent relative to the previous month, and the production pipeline looks like it will remain full, at least for the time being, as new orders were up 3.2 percent during the month. Retail sales fell in July relative to the previous month, but the year-over-year growth rate remains solid (see middle chart). If the 0.3 percent rise in the leading economic indicators index in August, which follows a 0.4 percent increase the previous month, is any indication, then the Canadian economy should continue to expand for some time.

So will the BoC continue to tighten policy despite the recent rate cuts on the American side of the border? Probably not, at least not for now. The BoC kept its policy rate unchanged earlier this month due in part to the uncertainties introduced into the outlook by the recent dislocations in credit markets. In addition, CPI inflation generally remains well behaved. As shown in the bottom chart, both the “headline” and the “core” CPI inflation rates remain well within the BoC’s target range of 2 percent to 3 percent. Benign inflation gives the BoC the luxury of waiting to see how dislocations in credit markets play out.

So, will the loonie strengthen further against the greenback? We think it will. Interest rate differentials probably will move further against the U.S. dollar if the Fed continues to ease lending policy. In addition, commodity prices show little prospect of coming down significantly. Finally, the trend, which has been running in the loonie’s favor, remains one of its best friends.

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Published on  Tue, Sep 25 2007, 08:53 GMT