Is a benign dollar policy wise?

• Author: Poole, William

Officially, the United States has a strong-dollar policy, whatever that is supposed to mean. In practice, what we see is a benign dollar policy, by which I mean that the United States is very unlikely to take any action to attempt to 'affect the value of the dollar on the foreign exchanges that it would not take for other reasons. My title asks the question "Is a Benign Dollar Policy Wise?" My answer is a resounding "yes."

Recent Behavior of the Dollar

Figure 1 shows the recent behavior of the dollar, which some observers regard with concern. (1) They focus on the decline in the dollar, but do not seem to have a long-run perspective.

Figures 2 and 3 provide a long-run perspective. When measured by the broad index, the dollar has strengthened over the years; measured by the major currency index, the dollar has depreciated. Even so, the major currency index is down by only about 26 percent since 1973, or a compound average depreciation of 0.84 percent per year. The shorter-run fluctuations are much more striking than the long-run trend. They are impossible to predict and difficult to explain even after the fact with statistically reliable models.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

[FIGURE 3 OMITTED]

The clearest episode providing an analog to today's concerns is dollar depreciation in the late 1970s, which was clearly connected to rising U.S. inflation and loss of confidence in the Federal Reserve. Those offering this explanation of depreciation between March and November 2009 often point to increases in the price of gold accompanying dollar depreciation as evidence of inflation concerns.

It is important to emphasize that that the rising dollar price of gold and the dollar depreciation are not two separate measures of inflation concern. Over the six months ending November 2009, the price of gold rose by about 9 percent in euros. The higher price increase in dollars, about 19 percent, simply reflects dollar depreciation against the euro. Thus, the question is whether dollar depreciation/gold price increases reflect market concerns with regard to U.S. inflation.

I myself am concerned that the Federal Reserve will not be successful in keeping inflation below, say, 2 percent at an manual rate as the economic recovery gathers strength. But my concern does not seem to be reflected in the Treasury bond market. Inflation compensation as measured by the spread between 10-year indexed and 10-year conventional bonds is still right around 2 percent. In recent years, inflation compensation has been between 1.6 percent and 2.6 percent most of the time. The increase in inflation compensation in 2009 was a consequence of an abnormal decline in the conventional 10-year Treasury bond in the fall of 2008, in part from a flight to safety after the Lehman failure and in part due to Federal Reserve hints in December 2008 that it would intervene heavily in the Treasury bond market to drive down yields. Figure 4 tells the story.

In sum, dollar depreciation in 2009 is not clear evidence of rising inflation concern in the market. Such concern...