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Tuesday, October 23, 2007

"The Dollar's Got Further to Slide"

Richard Clarida says the fall in the dollar isn't over yet:

The Dollar's Got Further to Slide, by Richard Clarida, Commentary, WSJ: Nearly every day in recent weeks seems to bring news that the dollar has fallen to record lows against the euro and other major currencies. Important factors include the Fed's bold -- but appropriate -- 50 basis-point cuts in the Federal Funds rate and the discount rate, and the policies we are likely to see in coming months from the European Central Bank and the Bank of England. ...

Since the August 2006 [FOMC] meeting, at which the Fed announced at least a pause if not an end to the interest-rate hike cycle, the dollar [has drifted downward]. [chart] There are several reasons for this, and these reasons suggest the dollar downdraft is likely to continue for some time to come. First, the U.S. economy in the second half of 2006 slipped into what has now been more than a year of below-trend growth. Moreover, this occurred in the context of buoyant global growth...

This relative U.S. underperformance is likely to continue, as the economy works through the headwinds of the housing contraction and consumer retrenchment in the face of tighter credit conditions and a soft labor market. But a U.S. recession is not necessarily in the cards, in large part because the Fed will probably ease more in future months to provide insurance against an economic contraction. ...

It appears as though the trade deficit has peaked, and it starting to decline as a result of slower U.S. growth, a robust global economy, and a weaker dollar. Indeed, all of the increase in the trade deficit between 2004 and 2006 was due to higher oil prices. The non-oil trade deficit has been more or less constant since 2004, and is now starting to show clear evidence of decline. ...

As the U.S. economy moves from being an engine of global growth to a path that is in line with the average of other major countries, the trade deficit will narrow and a weaker dollar will be part of that adjustment. This adjustment need not be inflationary.

Currencies can depreciate because of bad monetary policy, as was the case for the U.S. in the 1970s. But they can also depreciate with sound monetary policy if currency adjustment is called for -- as it is now -- to rebalance the domestic and global economies as the U.S. trade deficit shrinks.

The world financial system is undergoing an evolution, as economies from Asia to the Middle East to Europe allow more flexibility in their exchange rates and/or peg them against a basket of currencies and not just the dollar.

Reserve diversification will continue, and sovereign wealth funds will likely invest across a broader range of assets than reserve managers do at present. All of these developments will keep the dollar downdraft going for some time.

A U.S. inflation surge is not likely, although the Fed will face upward pressures on inflation from sources that were not so prominent until recent years -- a possible slowdown in productivity growth and booming commodity prices, as well as the weaker dollar.

But ultimately the U.S. inflation rate will be up to the Fed. At present, with core inflation measures within the Fed comfort zone, and payrolls contracting, the Fed is now rightly focused on cutting interest rates to preempt a U.S. recession.

    Posted by on Tuesday, October 23, 2007 at 12:33 AM in Economics, Inflation, International Finance | Permalink  TrackBack (0)  Comments (20)

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