The Dollar’s Value Isn’t Just Affected by US Policy

The New York Times Room for Debate posed this question, "Should the Fed be concerned that the strong dollar could slow down the domestic and international economic recovery?"

The dollar’s rise is evidence of the U.S. economy’s strength. But a strong dollar hurts U.S. exports and could be a problem for emerging market economies. Last week the Federal Reserve signaled that it might start raising interest rates later this year, a move that might further strengthen the dollar.

Should the Fed be concerned that the strong dollar could slow down the domestic and international economic recovery?

Scott Sumner provided the following response:

In the past few months, the euro has fallen from roughly $1.35 to $1.08, triggering concern that the dollar is becoming overvalued. Some economists have suggested that the Fed should ease monetary policy by printing money or holding down interest rates, in order to weaken the dollar in the foreign exchange markets.

But the foreign exchange value of the dollar is not a reliable indicator of whether monetary policy is easy or tight. For instance, expectations of more rapid economic growth in the United States could easily lead to an appreciation of the dollar. And yet obviously expectations of faster growth would not call for the Fed to print money or cut rates, which normally occurs when the economy slows.

There are cases where a strong currency can be an indicator that the Fed had not supplied enough money to the economy, which is slowing economic growth. The foreign exchange value of the dollar soared in the second half of 2008, and in retrospect the Fed should have printed more money and/or reduced interest rates even faster to encourage economic growth during that difficult period.

It is essential to keep in mind, however, that any foreign exchange rate reflects conditions in two economies, not one. In recent months the euro and the Japanese yen have depreciated in response to monetary stimulus by their respective central banks. The falling price of oil has pushed down the currencies of many commodity exporters.

None of these changes necessarily harm the U.S. economy. If one were going to argue that the strong dollar means that monetary policy is too tight in the United States, you'd have to also argue that a weak euro implies policy is too expansionary in Europe. It takes two currencies to produce an exchange rate, hence a stronger dollar means a weaker euro. And yet it makes little sense to view European Central Bank policy as excessively expansionary when the eurozone is experiencing deflation and high unemployment.

Fortunately, there are ways of getting beyond the ambiguous message contained in the exchange rate between two countries. We don't really want to know whether a currency is stronger or weaker relative to another currency, as that other currency might also be too strong or too weak. What we really need is some sort of absolute standard against which to judge the value of a currency.

The Fed’s 2 percent inflation target offers that sort of standard, measuring the value of the dollar in terms of its purchasing power over goods and services. If there is an argument for continuing the Fed's low rate policy, it's not to be found in the foreign exchange markets, but rather in the domestic bond market, where investors expect the Fed to continue undershooting its 2 percent inflation target.