The Dollar's Depreciation and Inflation
Factors underlying the dollar's depreciation may be changing in a manner that could put upward pressure on U.S. prices, should they continue. Nevertheless, dollar depreciations do not cause inflation. Inflation is a purely home-grown, monetary phenomenon.
Since early February 2002, the U.S. dollar has depreciated nearly 31 percent on a trade-weighted basis against the currencies of the major industrialized countries and has also depreciated more than 6 percent on a similar basis against the currencies of key developing countries. On a real basis - that is, after controlling for the effects of domestic and foreign inflation - the dollar has depreciated nearly 26 percent against the major industrialized countries' currencies and almost 7 percent against the key developing countries' currencies.
Economists have always found explaining movements in exchange rates difficult, even in hindsight, but comparing movements in the dollar with broad changes in the current-account deficit can provide some insight. Between early 2002 and late 2005, the dollar depreciated as the current-account deficit widened, suggesting that an expansion of U.S. aggregate demand motivated both events. U.S. economic growth at the time was not obviously faster than economic growth elsewhere across the globe, but between mid-2003 and late 2005, U.S. output converged on, and eventually surpassed, potential output quicker than was generally the case abroad. Americans consumed and invested more than they produced domestically. A small part of the dollar's depreciation against the currencies of the major industrialized countries reflected a slightly higher rate of inflation in the United States than in many other large industrialized countries. At best, this seems to explain only about 5 percentage points of the overall depreciation against our large trading partners; it describes none of the dollar's depreciation against the key developing countries.
Last year, however, the situation seemed to change. The dollar continued to depreciate, but the current-account deficit narrowed from a record 6.8 percent of GDP in the fourth quarter of 2005 to 5.7 percent of GDP in the first quarter of 2007. This pattern of exchange-rate and current-account movements, along with myriad anecdotal reports, tentatively suggests that foreign investors are becoming somewhat reluctant to acquire U.S. financial claims, although they are not outright dumping dollars.
Many analysts have been anticipating such a development. The United States has financed its persistent string of current account deficits by issuing financial claims to the rest of the world. As a consequence of this process, the world now holds financial claims amounting to $3.5 trillion against the United States, or 26 percent of our GDP. (Our negative net international investment position measures this.) Economists have long argued that the stock of outstanding financial claims could not grow continuously relative GDP (a comparison which indicates our ability to service and repay the claims). At some point, they argued, foreigners would become reluctant to add dollar-denominated assets to their portfolios. When this point was reached - and economists did not know when that might be - the dollar would depreciation and real interest rates in the United States might also rise to coax foreigners into holding additional dollar-denominated assets. The broad-based dollar depreciation since late 2005 is certainly consistent with this story.
The relative thrust of U.S. and foreign monetary policies may be encouraging international investors to diversify. Since June 2006, the FOMC has kept the federal funds target rate at 5.25 percent, while other key central banks have tightened. Markets do not expect the Federal Reserve to change policy anytime soon, but the chances are better than not that other central banks will move their key policy rates upward.
A dollar depreciation exerts upward pressure on U.S. prices through a couple of different channels, but how a depreciation affects the overall inflation rate depends on the stance of U.S. monetary policy. Inflation is, after all, purely a monetary phenomenon. A dollar depreciation lowers the foreign-currency prices of U.S. made goods and services, making our exports more attractive to foreigners. The resulting increase in foreign demand for U.S.-made traded goods raises their dollar prices. Similarly, a dollar depreciation increases the dollar prices of foreign-made goods and services. Many of these are consumer goods, and as their prices rise, U.S. consumers look for domestic substitutes, thereby also putting upward pressure on the prices of domestically produced alternatives. In addition, to the extent that imported goods enter into the production of domestically made goods and services, the dollar depreciation will raise the costs of domestic production. The bottom line is that a dollar depreciation will raise the relative price of all traded goods and any nontrade substitutes in this country, as well as domestic goods with a high import component in their manufacture. But this is not inflationary.
As long as U.S. monetary authorities have not caused the dollar depreciation because of an excessively easy monetary policy, and as long as U.S. monetary policymakers do not subsequently accommodate a dollar depreciation with an easier monetary policy, the price effects of a dollar depreciation will not lead to a general inflation in the United States . The dollar depreciation from 2002 through 2005 appears to have been a response to U.S. developments, including the stance of U.S. monetary policy. Import prices advanced apace with prices overall, and relative export prices rose only a bit faster than the consumer price index. The depreciation over the last year, however, seems foreign in origin. It has not had a price impact as of yet, but should it continue, this foreign-sourced dollar depreciation could complicate the conduct of monetary policy as it shifts worldwide demand towards the United States, but it will not cause inflation. That depends of the FOMC.