Monetary Policy and the Dollar?s Depreciation
The dollar has been depreciating in foreign-exchange markets since February 2002. But in early 2006, the underlying nature of the dollar's descent changed. Prior to that time, an expanding U.S. aggregate demand seemed to have provoked the dollar's decline, but thereafter, the diversification of international investors' portfolios away from dollar-denominated assets seemed to be the cause. This diversification and the associated depreciation can affect the U.S. macroeconomy along at least three key dimensions: trade, prices, and interest rates. For that reason, the sharpness and protracted nature of the depreciation have started to raise questions about possible implications for U.S. monetary policy and about possible policy responses to the dollar's fall.
The dollar depreciation has raised the dollar price of U.S. imports and lowered the foreign currency price of U.S. exports. These relative price changes shift demand in both the United States and the rest of the world toward U.S. goods and services. Our exports rise and our imports fall, directly benefiting U.S. firms that either sell abroad or compete against foreign firms in U.S. markets. At a time when housing-sector weakness threatens growth in other sectors of U.S. economy, a strong export sector is welcome news for policymakers.
As worldwide demand shifts toward U.S. goods and services, the dollar price of both our imported and exported goods will rise. (The foreign-currency prices of our exports fall, but the dollar prices of these goods rise.) These price pressures will ripple through the economy and become reflected in key aggregate price indexes. While such price pressures are not in themselves inflationary, they greatly complicate policymakers' ability to read the degree of inflationary pressure in the economy and to respond appropriately.
All else constant, a prolonged portfolio reshuffling away from dollar-denominated assets could leave real interest rates in the United States higher than they might otherwise be. The inflow of foreign investment funds that has accompanied the U.S. current account deficit since 1982 has allowed domestic investment to exceed domestic savings. As the current account deficit narrows and as these foreign financial inflows slow, domestic investment and savings must necessarily converge. Higher real interest rates are the mechanism that will achieve this convergence. They may imply a slower pace of U.S. investment or consumption, and they will complicate further the task of determining which federal funds rate target is neutral with respect to the economy and which federal funds rate setting is currently appropriate for achieving the Fed's dual mandate of price stability and maximum sustainable economic growth.
In the 1980s, when the dollar first appreciated and then depreciated, many observers thought that the United States should direct policy at offsetting - or at smoothing - the dollar's movements. Such a policy might minimize the economic effects of the change in the dollar's exchange value. At best, exchange-rate-focused policies are superfluous; at worst, they conflict with the Fed's dual mandate.
Focusing monetary policy on exchange rates presents the Federal Reserve with a potential mismatch between the number of policy instruments at its disposal and the number of policy objectives that it seeks to attain. Under its current dual mandate, the Federal Reserve focuses on achieving a federal-funds-rate target consistent with stable prices and economic growth at its potential. From time to time, the FOMC may lean one way or the other with respect to these dual objectives, but doing so generally does not present much of a conflict. Over the long-term, the FOMC's objectives are compatible, because the System can only raise the nation's potential for long-term economic growth by keeping inflation low and stable. Over the short-run, conflicts between objectives can arise, but often when economic growth falls below its potential rate, inflation tends to moderate, and when economic growth exceeds its potential rate, inflation tends to rise. In such cases, raising or lowering the federal funds rate promotes both the growth and inflation objectives. A serious problem arises when the economy confronts a supply shock - like rising oil prices - since supply shocks puts upward pressure on prices while simultaneously trimming economic growth. Supply shock can force the FOMC to choose between its inflation and growth objectives, but if its policy has been credible and is clearly articulated, temporarily doing so is possible.
Adding a third, exchange-rate objective to the Federal Reserve's mandates ramps up the instrument-versus-targets problem. If the dollar were depreciating because monetary policy was excessively easy, no conflict would be involved. Tightening monetary policy to slow the depreciation would be consistent with maintaining a stable prices and ultimately keeping economic growth at potential. In this case, however, adding an exchange-rate target to the Fed's mandate would be superfluous to the its other objectives. If, however, the dollar were depreciating because of a diversification out of dollars, an attempt to slow the pace of depreciation would necessarily conflict with one or both of the Fed's other objectives. Should the FOMC be tightening to slow the dollar's depreciation when financial markets need liquidity and economic growth is likely to slow?
Some observers might recommend that the Federal Reserve slow the dollar's depreciation through sterilized sales of foreign exchange. To conduct a sterilized sale, the Fed would sell euros or yen for dollars and offset or "sterilize" the decline in dollar reserves by buying U.S. Treasury securities from the banking system. This set of transactions would not interfere with the FOMC's federal funds rate target and, therefore, with the Fed's price and growth objectives. Sterilized interventions can sometimes temporarily affect exchange rates, but because they do not change the underlying macroeconomic determinants of exchange rates, their impact is at best ephemeral.