Kurt Brouwer June 9th, 2008
As you know, the dollar has been falling against the Euro for several years. But, when you hear that the dollar has fallen to historic lows versus the Euro for example, it is sometimes hard to put that in an actual historic perspective. Also, for most Americans, it’s hard to understand why the dollar is falling. With this post, the goal is to give you the best answers available on both questions — How far has the dollar fallen? And why is it falling? We also want to look ahead as well.
Let’s start with how far the dollar has fallen. One problem with our media is that the news of the day is often one-sided and it seldom comes with any historical perspective. For example, do you remember hearing that the Euro fell to historic lows versus the dollar? Well, as you will see from the chart below, it happened not too long ago. In fact, the Euro fell steadily versus the dollar for the first five years of its existence, beginning in January 1999. It did not get back to even until mid-November, 2003. At the low point for the Euro you could have bought one for 84 cents. Now, it takes a $1.56.
Here is a chart showing the fluctuations of the Euro versus the dollar since inception in 1999. This shows how many dollars it takes to buy one Euro. When the blue line is heading down, the dollar is getting stronger. When the line heads up, the dollar is getting weaker.
U.S. Dollar / Euro
Source: St. Louis Federal Reserve Bank
The gray bar in the charts indicates the relatively brief recession we experienced in 2001. You might notice that the recession coincided with the low point for the Euro (or conversely, the strongest point for the dollar during this time period). In other words, the very strong dollar and the recession went hand in hand because the Federal Reserve raised interest rates beginning in 1999 and that led to the recession. Higher rates cause the dollar to strengthen, but they also inevitably slow down the economy. On the other hand, lower interest rates are positive for the economy, but often not for the dollar.
Now, our economy has been strong for over five years and the dollar has fallen, more or less continuously during this economic upturn. Coincidence? No. Here is a chart showing the Federal Funds target rate for the same period.
Federal Funds Rate
Source: St. Louis Federal Reserve Bank
As you can see from the second chart, the Federal Reserve began raising interest rates to slow down the technology bubble in 1999. As seen on the top chart, when U.S. interest rates went up, the dollar rose versus the Euro. When the economy fell into recession in 2001 (the area in gray), the Fed began slashing interest rates and the Euro finally began strengthening versus the dollar. The Fed began raising rates again in 2004 due to inflation concerns and the Euro stabilized versus the dollar until the Fed stopped raising rates in 2006. At that point, the Euro began climbing and the process accelerated when U.S interest rates were cut in 2007 as the economy began to weaken.
The big difficulty we face now is that the economy is weak and the Fed would like to cut interest rates or at least maintain them at a low level. The Fed cuts rates when it is concerned with economic weakness. As we have seen, lower interest rates helps the economy, but lower rates generally hurt the dollar versus the Euro. Due to weakness in the dollar, the response would ideally be to raise interest rates to help strengthen it. Inflation is also picking up steam and the normal response to that would be to raise short-term interest rates. Obviously, we cannot both raise and lower interest rates, so the Fed is hampered in its ability to respond to this situation.
In my opinion, this is not the fault of current Fed Chairman, Ben Bernanke, but instead the roots of this problem date back to the previous chairman, Alan Greenspan, who maintained very low interest rates for too long after the recession of 2001 and the terror attacks of 9-11.
The Fed’s current posture is that we should not expect any additional cuts to the Fed Funds rate. And, in all likelihood, we will see higher Fed Funds rates late this year or early next year as the economy begins to pick up steam. As a result, the dollar has shown a little strength lately. So the dollar should stabilize roughly around this level or a bit higher for a while and then we should see some strengthening when interest rates begin moving up (see Is the Euro Headed For a Fall?).
To put this entire discussion of the decline of the dollar in perspective, let’s look at one additional chart of the dollar versus another currency, the British pound sterling.
U.S. Dollar / British Pound
Source: St. Louis Federal Reserve Bank
This chart shows that in 1972 it took over 2.5 dollars to buy one pound. The dollar then strengthened versus the pound and this process ended in 1985 when it took only $1.10 to buy a pound. Since 1985, the pound has generally strengthened versus the dollar. That is, for the past 23 years the dollar has generally fallen versus the pound. Yet, even at the recent peak of strength for the pound — October 2007 — the pound has still not made it back to the high point it reached versus the dollar back in 1972.
In short, major currencies fluctuate against each other daily, but the overall trends cover very long periods of time. If you look at the dollar/pound comparison over a shorter period, then you see the dollar is weakening. But, if you look over the longer period shown in the chart, then you see the pound on a long-term downward trend versus the dollar.
I hope this clears up some of the confusion and also allays some of your concerns. The dollar has always fluctuated against other currencies and this is nothing new. We have some work ahead of us to deal with the contradictory implications of a sluggish economy plus resurgent inflation and a weak dollar. However, this too is nothing particularly new.
Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates
I remember the great difficulties we faced in the late 1970s and early 1980s. We had sky-high inflation, unemployment and mortgages rates. At that time, the Federal Reserve’s Chairman was Paul Volcker and he had to raise interest rates to unheard of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Paul Volcker’s, biography on Wikipedia gives a sense of how severe the reaction was [emphasis added]:
…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building. …
Blockading farmers. It sounds almost French, doesn’t it? It’s hard to imagine that scenario now, but those were tough times.
The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982. As inflation ratcheted higher, so did home mortgages rates.
Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!
But, even though high interest rates began knocking down inflation, high rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984.
When you hear politicians and pundits opine that this is the worst crisis since the Depression, just mentally compare current conditions to those of the late 1970s and early 1980s. We had double digit inflation, unemployment and home mortgage rates back then. Let’s see: inflation is around 4%, unemployment is 5.5% and 30-year fixed mortgages are about 6.25%. In other words, we are not remotely close to anything like double digits on any one of these factors, much less all three.
The difficulties we faced in the 1970s and 1980s were far more severe than anything we are seeing now and I am confident that the Fed and the U.S. Treasury will be able to deal with the much more moderate economic problems we are facing. We clearly have issues now, but they are not nearly as difficult as the issues we have successfully overcome in the past.
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