Should the Fed Prop Up the Buck?
Congress mandates the Federal Reserve “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Maintaining price stability over the long term is, of course, absolutely indispensable for achieving the other objectives. Recently, some observers have suggested that the Federal Reserve pay more attention to the dollar, but adding an exchange-rate objective to the existing menu could greatly complicate the Fed’s ability to hit its key domestic objectives. A lot depends on what the reasons behind the dollar’s depreciation are.
If, for example, the Federal Reserve were supplying more money than the public wanted to hold, the dollar would depreciate and inflation in the United States would start to rise. In such a situation, the dollar might actually depreciate in response to the excessive monetary policy even before goods prices started to move. In this case, tightening monetary policy to slow the dollar’s depreciation would be consistent with price stability, but simply focusing monetary policy on price stability and ignoring the dollar would achieve the desired outcome. At best, the Federal Reserve might keep an eye on the dollar, along with the other data that it monitors, as an indicator of potential inflation pressures, but it would not need to treat exchange rates as an objective.
If, however, the dollar were depreciating because foreign investors were diversifying their portfolios away from dollar-denominated assets, then targeting monetary policy on the exchange rate could easily interfere with price stability. In this case, tightening monetary policy would moderate and eventually reverse the dollar’s depreciation, but it also would slow the pace of economic growth and pull inflation below an acceptable level. Generally, any time factors other than domestic monetary policy are causing dollar exchange rates to move, targeting an exchange rate with monetary policy is a bad idea.
Since its recent peak in February 2002, the U.S. dollar has depreciated nearly 25 percent on average against our major trading partners. Initially, the dollar depreciation seemed to reflect the expansion of U.S. aggregate demand after the 2001 recession. Monetary policy was fairly accommodative, particularly between mid-2003 and mid-2004. Inflation and inflation expectations rose somewhat, but inflation in the United States was, on balance, only a bit higher than the average rate of inflation among our trading partners.
Since the end of 2005—at least through the end of last year—the dollar depreciation seemed to reflect portfolio shifts. Global investors are not overtly dumping dollars, but they seem reluctant to add dollars to their portfolios as fast as they are adding euros, which puts downward pressure on dollar exchange rates. Since August of last year, the Federal Reserve has cut the federal funds rate target by 300 basis points in an effort to ease liquidity problems in financial markets and to head off a recession. The easing of policy appears to have hastened the pace of diversification, but inflation expectations still seem fairly well contained. Inflation does not seem to be driving the dollar’s decline.
Admittedly, we are a bit uncertain about what factors have dominated the dollar’s dive in recent months, but that just reinforces our point. At any particular time, central banks may be uncertain about exactly which fundamentals are causing exchange rates to change. If a central bank guesses wrong, using the exchange rate as a target for monetary policy can have serious implications for achieving its domestic goals, so most central banks simply eschew exchange-rate objectives. The conflict between domestic objectives and exchange-rate targets ended the perennially beleaguered Bretton Woods fixed-exchange-rate system and initiated generalized floating in 1973.
Some observers suggest that the United States, ideally in conjunction with the Bank of Japan and the European Central Bank, undertake sterilized intervention to prevent further dollar depreciation. Sterilized interventions refer to purchases or sales of foreign exchange that are not allowed to affect the amount of dollar reserves in the banking system. Hence sterilized intervention cannot interfere with a central bank’s domestic mandates. The United States and other central banks that operate with an over-night interest-rate target routinely sterilize their interventions because they do not allow them to interfere with achieving the interest rate target.
Sterilized intervention can affect exchange rates in the desired direction, but it is a hit-or-miss proposition. The odds of success seem to increase if the intervention is large, conducted infrequently, and coordinated among central banks. Nevertheless, sterilized intervention does not change any fundamental determinants of exchange rates, so while it may give exchange rates an occasional nudge, it is of little lasting consequence.
Against this limited effectiveness central banks must weigh one final problem: Sterilized intervention may confuse markets about monetary policy. Suppose, for example, that a central bank is easing policy to achieve a domestic object, but is simultaneously buying its currency through sterilized foreign-exchange operations. Even though the intervention is sterilized, the domestic and exchange-market operations may appear to be at cross purposes. They may leave markets unsure about the central bank’s commitment to its domestic objectives. As such, they are not conducive to policy transparency.
It took central banks nearly 30 years to learn that intervention often conflicted with good monetary policy. Hopefully, the lessons will not be lost.