Last weekend's G-7 summit in Boca Raton created no surprises. Stock portfolio managers had been trimming their holdings aggressively the week before, fearful of some obnoxious headline, like, "G-7 Nations Agree to Stem Dollar's Fall." Nope. And the bond bears got disappointed, too.
Once again, the weak dollar headed two agendas, the public and the private. The result of both? The Bush administration has decided to allow the dollar to continue to seek its own level -- which means the dollar will continue to fall in relation to other key currencies, notably the Euro and the Yen.
The day after Inauguration Day in 2001, with the economy tanking, the new administration found itself with very few tools to use to get things moving again. The Federal Reserve funds rate was already low, at about 5.5 percent. (See chart here.) The Fed would lower it steadily over the next year and nine months, to near 3 percent. Tax cuts would help, but that would have to wait to pass Congress.
What was left? You could spend to stimulate demand -- classic Keynesianism, with a political cost for a Republican. And you could let the dollar fall. Absent unusual Federal Reserve buying of U.S. currency, that would happen by itself (the U.S. carries a large foreign trade deficit). No one knew exactly how far it would fall, unsupported. Somebody probably floated the idea of a weaker dollar very early on in the Bush administration. It probably elicited grumbles and worries. There was still some room for the Fed's monetary policies to work as of January 2001. As my favorite market expert tells me, there is comparatively little a President can do to set the price of money. Somebody probably decided it was worth a try -- but not right then.
And you couldn't exactly talk about it.
THE TIME TO TRY A WEAK dollar came after September 11, 2001, with the collapse of the stock markets. The Fed didn't have much more room to lower interest rates. The need to use any and all means to reflate the economy became urgent indeed. The Coolidge-preferred remedy -- letting the slump fix itself -- wouldn't work in this case, because the U.S. economy was near deflation, a condition unknown, or at least unappreciated, in the 1920s. Since Japan's collapse into deflation in 1990s, economists appreciate the condition a great deal. The U.S. did not want to go there.
It's now evident that the Bush administration has used every one of its economic weapons, including a weaker dollar. So what has happened since? And what will happen now?
First, the dollar has indeed fallen in world currency markets, losing about 50 percent of its value against the Euro. For about nine months, that fall stimulated a bull market in gold and gold stocks, with the top predictably signaled when bullion brokers started advertising on the radio, saying gold "could go to" $800 an ounce. Nowhere near. For charts of gold prices over the last year in various world currencies, go here. Note that gold actually fell in price in Australian dollars and in South African Rand.
Second, European countries, Japan, and China do not like the weak dollar policy. The U.S. dollar is the currency of record for the world, and U.S. securities offer safe havens for investing -- particularly U.S. Treasury securities. Japan's central bank has been forced to sell yen to keep yen from rising more steeply against the dollar. The EU has been forced to contemplate raising interest rates, which the UK just did late last week. The European economy is recovering; Brussels fears choking off that recovery with higher interest rates. But if their exports decline due to a stronger currency, the recovery may level off anyway.
IN SUM, THE WEAK DOLLAR policy has created a multi-faceted tug o'war. The U.S. bond market, which thrives on bad news (prices jumped when ricin was discovered in Senate Majority Leader Bill Frist's office, for example), cannot seem to decide whether a weak dollar is good news or bad. More precisely, the bond market has no opinion on the weak dollar itself, but does not like the weak dollar's result, a rising stock market and good and growing economic numbers. But suppose foreign countries were to pull out of the U.S. stock and bond markets because the dollar got so weak? Suppose the U.S. account deficit with foreign trading partners grew so large that the world began to move toward another "currency of record"?
For now, a sort of productive standoff has been achieved. The dollar tugs interest rates both up and down, the Fed will apparently refrain from raising rates at least until mid-summer, foreign buyers still like U.S. securities, and unless this G-7 summit issues a radically different statement from the last one, things will remain much the same for a while yet.
The weak dollar, for now, is working the way it is supposed to. But a weak dollar strategy, like any investment or financial strategy, will only work for so long.
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