Does the Rally In the Dollar Have Long Legs?

The value of the dollar in foreign exchange markets has been rising for several weeks, and is now at its highest level in 4 years. This flies in the face of many Fed critics who have been predicting its policies during this period would destroy the dollar’s place as a reserve currency, with dire consequences for inflation and government borrowing costs. Is this trend likely to continue and how far might it go? Here the dollar’s historic movements against the currencies of two major trading partners, the euro and the Japanese yen, offer some clues.

The euro began trading at the start of 1999 at an exchange rate of 1.2 dollars per euro, and that exchange rate underwent very wide swings in the years that followed. The euro first weakened to a low around 0.85 during 2000-2002 and then nearly doubled to a high around 1.60 in 2008 just before the financial crisis. Inflation differentials can account for very little of this huge swing. Neither the Eurozone countries nor the U.S. directly manipulate their currencies. And both experienced the same major economic shocks. So the most plausible explanation for the euro’s strength in this period is that the possibility that it would become a second reserve currency led countries to start building euro reserves and bidding up their price. In the years since the crisis, the dollar-euro exchange rate has fluctuated between1.25 and 1.50. And most recently the dollar strengthened to 1.27.

The yen has been a very different matter, with Japan controlling its exchange rate in order to develop its export markets after the war. By 1985, Japanese cars and consumer electronics had gained such a large share of the U.S. market that the world’s central bankers forced them to allow the yen to appreciate. From 250 yen to the dollar at the time of the Accord, the yen rose to 150 over the next three years, and to 100 by 1995. But the rigged exchange rates of the boom years were only the most visible of Japan’s policy distortions which had also led to unsustainable bubbles in real estate and the stock market.

These bubbles burst by the end of the decade, and Japan has never gotten back on a satisfactory growth track since. When Shinzo Abe became Prime Minister, he promised to think outside the traditional policy box, and thus far he has promoted an aggressively easy monetary policy and a depreciation of the yen over the past year. But a perversely tighter fiscal policy, in the form of a hike in consumption taxes this spring, has slowed the economy again. And it is unclear what Abe will accomplish with his promise of structural improvements to the economy. Given these prospects, a further weakening of the yen against the dollar may be the main hope for getting the economy moving. And there is ample history to show he can do so by aggressive monetary easing and investing in foreign assets.

So how about the dollar today? Currency movements are notoriously hard to predict. But today several developments suggest we could be in the middle stages of a sustained dollar appreciation. The U.S. expansion is at present stronger and more secure than the expansions in other advanced economies. The ECB’s Mario Draghi is aggressively easing and looking for a more competitive exchange rate to help the economies of the eurozone, just as Abe is likely to do in Japan. The stronger U.S. expansion also makes it an attractive destination for private sector equity investments through purchases of U.S. stocks and real estate, and through firm mergers and acquisitions.

The development of the U.S. oil industry will affect the dollar through at least two channels. It has already started to improve the trade balance, and will improve it much more as legal and capacity restrictions on energy exports are lifted. And the presence of low cost energy is a further incentive for foreign firms to invest in the U.S. Finally, the enthusiasm for the euro as a reserve currency has been dampened by the problems with the currency union that the crisis exposed.

History shows that exchange rate movements can go a long way once they get started, especially when there are sound economic reasons behind them. So it would not be surprising if the dollar strengthens further from here and the time to raise interest rates is pushed further into the future.