Setser: Understanding the Falling Dollar

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Brad W. Setser, a fellow at CFR’s Center for Geoeconomic Studies and an expert on currencies, outlines the factors leading to the precipitous recent fall in the valuation of the U.S. dollar. Setser says expectations that the U.S. Federal Reserve will make further rate cuts have added to the dollar’s decline, and says more generally that some countries with large dollar reserves are becoming less comfortable sitting on these reserves. He says the Fed shouldn’t attempt to use interest rates to sway currency exchange rates, but should focus instead on guaranteeing domestic economic stability, adding that it would take a “rather extraordinary series of events” to create a situation in which the United States ought to intervene directly in currency markets by coordinating the sale of euros or yen and buying dollars.

The dollar has fallen quite fast in recent weeks. Last week it hit record lows against the euro and it’s now trading below the value of the Canadian dollar. Why is this happening now?

Well, there are a few reasons. One is that the subprime crisis of the summer shook the world’s confidence in certain kinds of U.S. financial assets—particularly the more complicated, so-called structured products, derivatives based on housing-market debt. And as the private demand for U.S. debt fell, that correspondingly had an impact on the dollar. If the attractiveness of one kind of financial asset that the economy is producing falls, and demand for other kinds of financial assets does not rise commensurately, the net effect is that there’s less demand for your assets and your currency.

I think more importantly, the credit crunch of the summer—or the possibility that the difficulties in U.S. credit markets might lead to a credit crunch and a meaningful economic slowdown—have changed the market’s expectations about the likely path of the Federal Reserve. The Federal Reserve first cut rates by fifty basis points, then cut again, and the market expects further cuts in the Fed’s policy rates. So the interest rate differential, or the fact that U.S. interest rates were higher than European rates, is no longer the case. And as U.S. interest rates have fallen, the attractiveness of holding the dollar, relative to the euro, has gone down.

Finally, my best guess is that several oil exporters are a bit less willing to hold on to dollars than they used to be, and that’s an additional source of pressure on the dollar.

How much power do governments have to control the value of their currency internationally?

There are two components to that. One is what sort of power does the U.S. government have, and by that I specifically mean the U.S. Federal Reserve. Most people believe that short-term interest rates do have a meaningful impact on the relative value of different currencies. So monetary policy can be used to defend a country’s currency. The real question there is should it be used to defend a country’s currency, or should monetary policy be directed at domestic objectives.  Certainly most economists’ views, and I share that view, is that the core goal of U.S. monetary policy should be stabilizing U.S. domestic conditions, not trying to stabilize the value of the dollar. So the policy tool the U.S. has that most obviously would impact the value of the dollar right now is not used to stabilize the exchange rate, it’s used to stabilize domestic conditions in the U.S. And given that right now domestic conditions in the U.S. are such that policy interest rates have come down, that’s actually working against the dollar.

Then I think on the other side, the dollar is being supported, even now, by the resistance in many Asian economies—not just Asia, also many emerging economies around the world—to any strong increase in the value of their currencies against the value of the dollar. And by intervening to hold their currencies down, they are in effect holding the dollar up, not necessarily against the euro but against their own currencies. So I certainly think that has an impact.

Is there any situation in which you think U.S. intervention to stabilize the dollar would be appropriate?

We have to differentiate between a decision on the part of the Fed to direct its monetary policy toward supporting the dollar, which I don’t think would be appropriate. It’s also not really consistent with the Fed’s mandate. But I do think it’s appropriate for the Fed to consider how a weak dollar might impact its ability to achieve its domestic goals—including the goal of price stability—which provides a context in which the Federal Reserve might be less willing than it otherwise would be to reduce U.S. policy rates because of concerns that a falling dollar might feed higher inflation. I think that’s a legitimate consideration for policy.

Then a second mechanism would be direct intervention in the foreign exchange market. That’s something that other countries do rather regularly, but the U.S. has not done on a consistent basis for a long time, and the Bush administration hasn’t done at all. And I certainly think that’s a tool that shouldn’t be ruled out, though I think it would take a rather extraordinary series of events in order for it to be used.

How do you do that? How do you intervene in the foreign exchange market?

Well the United States has some euros and yen that it holds. The Treasury has some euros and yen that it holds. And it could sell euros and buy dollars. Typically, the intervention would be done jointly, it would be done with, say, the European Central Bank, which would also buy dollars.

There’s some concern that China will rapidly sell down its dollar reserves and that that will push down the dollar even further. How fast could they do that, feasibly, and is it a problem for the United States?

I would define the problem a little differently. We are in a world where Chinese reserves are growing rather rapidly, and China’s holdings of dollars are growing rapidly, and the rapid increase in China’s dollar holdings is providing a rather significant amount of financing to the United States. It’s helping finance a significant share of the U.S. current account deficit. So the issue isn’t whether China sells its existing dollars. It’s whether China remains willing to add to its already large holdings, to add even more dollars to its large holdings. Chinese reserves increased by $250 billion in the first half of this year. The pace of growth slowed a little bit in the third quarter, but it’s not clear whether all of China’s foreign asset accumulation is showing up at the central bank in the form of higher reserves. Add those things up and China is on track to add between $450 and $500 billion to its assets this year. And the real issue is whether it’s willing to put as large a share of that increase into dollars as has been the case in the past. I think there’s an increasing debate within China about whether the rapid increase in its dollar holdings continues to serve China’s interest.

But in my mind, so long as China resists more rapid appreciation of the renminbi [China’s currency] versus the dollar, it’s rather difficult for China to diversify in any meaningful way against the dollar. If China really started to diversify away from the dollar, I think it’s a big enough player that it would put downward additional pressure on the dollar. So long as China itself pegs to the dollar or manages its currency primarily against the dollar—technically China has a crawling peg, and it’s clear from a range of economic analysis that it’s crawling mostly against the dollar, not against a true currency basket—then if it puts pressure against the dollar, it’s also putting pressure against its own currency. And given current economic conditions in China, I’m not sure that’s something China wants to do. So that’s a meaningful constraint on China’s ability to change its portfolio. But I would note that since maintaining the current value of the renminbi versus the dollar requires China buy a lot of dollars, not just hold onto its existing stock of dollars, means that keeping the dollar from falling and keeping the value of China’s current dollar holdings constant, means that China has to continually increase its exposure.

Are countries in East Asia concerned that a falling dollar will hurt their exports?

Countries that peg to the dollar are seeing the value of their currencies fall against the euro and are seeing a rapid increase in their exports to Europe. So for many countries, the concern isn’t that a fall in the dollar will lead to a fall in their exports. It’s that economic weakness in the U.S. will spread to Europe, and that the broader reduction in global growth will lead to a reduction in their export growth.

Now there are specific concerns in countries like India and Thailand that have let their currencies appreciate against the dollar and the renminbi—they are a little worried that China will undercut them in global markets. As a result, they’ve been resisting further appreciation in their currencies. But I would put a great deal more emphasis on concerns that U.S. weakness may be the leading edge of a broader global slowdown. Specific Asian economies, particularly those like China that are doing very well and are pegged to the dollar, worry that there’s a growing difference between the domestic needs of their own economies—their own economic conditions likely call for probably higher interest rates and a stronger currency—and the economic and monetary policy that they’re importing by virtue of their peg to the U.S. dollar.

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