Professor Paul Palley's
          Economics Seminars

The value of the dollar has declined versus other important currencies for years. One dollar bought over 230 yen in January 1980 and over 300 yen in the early 1970s, versus just over 100 yen today. One euro bought about one dollar in January 2003 and often less than one dollar before this date, but now one euro buys nearly $1.60. See the Federal Reserve Bank of St Louis for this data; http://research.stlouisfed.org/fred2/categories/15. The value of the dollar is in the news more and more today, and as international trade increasingly becomes more important to the United States, exchange rates will only become increasingly important to people. The questions then are, why has the dollar weakened in value over time and what does this mean for the United States.

The decline in the value of the dollar versus the yen is most easily explained by focusing on the trade deficit the United States has with Japan. The United States currently runs an annual trade deficit of goods and services equal to about seventy billion dollars with Japan (see the Bureau of economic Analysis for this data; http://www.bea.gov/international/bp_web/list.cfm?anon=71&registered=0). The trade deficit results in sales of dollars in the foreign exchange markets in order to buy the yen needed to import these goods and services. In other words, this increase in the supply of dollars results in a decrease in the value of the dollar relative to the Yen. Over the years, other factors have also contributed to changes in the exchange rate between the dollar and the yen including; interest rates, economic growth, and the performance of the financial markets in each country.

The declining value of the dollar versus the euro is largely affected by changes in the overall trade balance between the United States and the rest of the world. Data related to the trade balance on a goods and services basis indicates approximate equality between the United States and the rest of the world prior to 1980, Thereafter there has been a significant pattern of large trade deficits, and today the deficit on a goods and services basis approximately two hundred billion dollars. For this data, see the Federal Reserve Bank of St. Louis; http://research.stlouisfed.org/fred2/series/BOPBGS?cid=125. These large trade deficits have contributed to a weaker dollar relative to the euro.

The reason why I have focused on the overall trade picture in discussing the value of the dollar relative to the euro has a lot to do with the euro representing an alternative to the dollar as a global reserve currency. The European Union is approximately equal in size with the United States in terms of its economy and population. Furthermore, most people perceive Europe to be equally stable politically and economically. That being said, other important factors affecting the value of the dollar relative to the euro include interest rates, economic growth, and financial markets. The European Central Bank has in recent years tended to keep interest rates higher than the Federal Reserve has because of their stronger focus on fighting inflation, and these higher interest rates have led to a greater demand for the euro.

The impact of the weaker dollar on people in the United States is increasingly becoming evident. For example, the weaker dollar contributes to higher oil prices because oil is priced in dollars. The weaker dollar also contributes to higher rates of inflation in general because foreign producers will have to raise the prices of their products in order to stabilize their profits. Therefore, these higher prices tend to increase the inflation rate and contribute to higher interest rates. On the other hand, the weaker dollar positively impacts exports from the United States because the weaker dollar makes products made in the United States more competitive in foreign markets.

The Federal Open Market Committee (FOMC) decided on June 25, 2008 to leave its target for the federal funds rate at 2%. The Federal Reserve has incrementally dropped its target for the federal funds rate from the 5.25% it was in the middle of 2007 to its current level. In its statement, the FOMC indicated that it sees the economy growing primarily due to small increases in household spending. On the other hand, the labor market remains weak, the housing market continues to contract, energy prices are high, and the financial markets are stressed. The FOMC further reported that uncertainty about the inflation outlook remains high because of high energy and commodities prices even as they expect that inflation will moderate later this year and next year.

The Federal Reserve’s statement raised the issue of its focus on inflation, and particularly inflation expectations. This is important because it is generally believed that their policy goal of stable prices is, over time, the primary focus of the policy makers. Supporting the expectation that at some point in the near future the Fed will start raising their target for the federal funds rate in response to inflation is the statement issued by the FOMC, and Dallas Federal Reserve Bank president Richard Fisher’s vote for a rate hike (the other members of the FOMC voted to leave rates unchanged). With the Federal Reserve indicating that the risk for higher inflation expectations is higher, it is highly probable that more members of the FOMC will vote for rate increases later this year or early next year.

In a sense, the Federal Reserve is stuck in a very uncomfortable position. The weak economy tends to argue for relatively low interest rates in order to spur economic growth. On the other hand, higher inflation rates demand higher interest rates for two very practical reasons. The first is that lenders demand higher interest rates in order to produce a justified real rate of return on their investment. This point indicates that short and long-term market rates will remain relatively high in comparison with the federal funds rate or rise, and as a result the Federal Reserve can find itself behind the curve, and this is a condition many argue already exists. The second reason for the FOMC to raise its target for the federal funds rate is the fact that higher rates tend to restrain economic growth and as a result lead to a lower inflation rate. On the other hand, if energy and commodity price inflation does not spread to the rest of the economy in a significant way then the FOMC can wait to raise rates.

The point I made about short and long-term market rates remaining relatively high compared to the federal funds rate is evident in the financial markets. Consumer and mortgage lending rates have not followed the federal funds rate down, and in fact have increased. Mortgage rates and the yield on 10-year Treasury note have increased in response to higher inflation expectations even as the housing market has weakened. I must add though, on the other hand, that from a historical perspective these rates are still historically low. If the FOMC raises its target for the federal funds rate, the prime interest rate will increase, and credit card rates will also increase, and this will further stress households.

The record high oil and gas prices we are seeing, and strong profits being earned by Exxon/Mobil and other firms have attracted the attention of very nearly everyone. The issues related to this that each person will focus on will be different, but the concerns for their budgets and the economy are equally important.

Oil prices are determined in a very competitive free market. Anyone is free to trade oil futures. So, while total supply can be dictated to a great extent by OPEC, Russia, Canada, and other major oil producers, still oil prices are largely determined in the market place. Adding to difficulties is the fact that the U.S. is highly dependent on gasoline and oil. Significant gains in efficiency have occurred over the last thirty years, but still we primarily depend on cars and trucks for transportation and many people use large trucks and SUVs that are particularly inefficient. Secondly, little or insignificant levels of investment in new technologies, alternatives sources of energy, and mass transit has occurred despite the clear need for this during this period of time.

It is very tempting to lash out at firms like Exxon/Mobil and the other oil firms that are reaping the benefits of the free market. Yet, in many ways they are not necessarily the only source of the issues affecting consumers. There are many reasons for this, but one important reason is that we have a shortage of refineries in the U.S. restricting supply and raising gas and other fuel prices. Why is this? Clearly not many people want a refinery in their backyard. Secondly, exploration for oil and gas has lagged immediate demands, but it must be noted that it takes as long as a decade for new wells to produce oil, the new oil will only affect the global oil market, and any reductions in price in the future will be minimal at best. Finally, where criticism can be directed is the willingness of oil companies to remain primarily just oil companies rather than investing in the research and development of new technologies to becoming more clearly diversified energy companies. In addition, we must note that oil companies and other firms in this industry receive significant government subsidies and that in some way the need for imported oil affects strategic military, defense, and foreign policies.

The only real long term answers are to develop new technologies that lead to greater fuel efficiency, create alternative sources of energy, and encourage people to drive more fuel efficient cars and trucks. Conservation efforts combined with investments in new technologies will be expensive, but will make the U.S. more energy independent and develop new technologies and industries. Economics also suggests that a significant increase in gas prices will help lead to this. The question is who will realize the revenues? Oil and gas prices will definitely increase over the long-run as China, India, Russia, and other economies grow and demand more energy and oil resources are inevitably depleted over time. A real problem is also that a lot of that oil comes from countries that can create real security risks for people in the U.S., Europe, and many other people.

Because of these points many economists advocate increasing the gas tax and then adjusting it up or down depending on changes in market conditions so that the price at the pump is around $4.00 per gallon or more and some suggest setting a floor at $6.00 per gallon. Why these numbers? The reason is that gas prices this high are prompting some changes in behavior. In fact both conservative and liberal analysts are recommending the same policy combined with stepped up investments in new technologies. This argument revolves around the points that prices will get there at some point in the future, and higher prices will force adjustments that people will have to make to greater fuel efficiency. Plus, the government can use the money to invest in research and development, building infrastructure, education, and for other purposes.

Very good sources of information related to energy prices and forecasts include the U.S. Department of Energy (http://www.doe.gov/) and the International Energy Agency (http://www.iea.org/).

With the economy as weak as it is, and possibly in recession, it might seem to be counterintuitive at this time to be thinking about the prospect of the Federal Reserve raising interest rates. However, given higher oil prices, higher food prices, and a generally higher inflation rate, it is logical to think about higher interest rates. Adding to the pressure in this direction is the weaker dollar, something that contributes to higher commodities prices in general, and in particular higher oil prices. While the Federal Reserve’s policy goals are balanced economic growth, full employment, and stable prices, it is thought that the primary goal is stable prices or low rates of inflation. Given this, and the price pressures we are witnessing in our daily lives, we can easily understand the focus on a change in the Federal Reserve’s monetary policies.

The press has picked up on this. On June 10, 2008 on CNNMoney.com (see the link below), there was a story about possible Fed rate hikes. Fed Chairman, Ben Bernanke, explicitly made a statement supporting a stronger dollar on Monday, June 9. The Federal Reserve Bank of New York president, Timothy Geithner, expressed similar sentiments. A contributing factor to the weaker dollar is the difference between lending rates in the U.S. and Europe. Lower interest rates in the U.S. tend to lead to a weaker dollar. The Federal Reserve’s target for the federal funds rate is 2%, but the European Central Bank’s target rate is 4%. This differential combined with large trade deficits will only contribute to a weaker dollar against the Euro and higher commodities prices including higher oil prices. The New York Times (see the link below) covered this issue the next day, reporting that in part due to Ben Bernanke’s statements, the yield on the 2-year Treasury Bill rose sharply on June 10. The value of the dollar rose in response to this.

These facts are increasingly leading to the conclusion that the Fed is finished with rate cuts, and that if their next move will not be higher interest rates then it will be a signal that this is coming. Another contributing factor is statements made by the president of European Central Bank, Jean-Claude Trichet, indicating that interest rates are likely to rise in Europe between now and July. These moves would weaken the economy further, but are designed to strengthen efforts to fight inflation.

Finally, on June 11, 2008 in Bloomberg.com (see the link below) it was reported that a survey of Bloomberg users indicated the forecast that the price of government bonds will fall in the Americas, Asia, and Europe over the next six months. It is higher inflation expectations that lead to the forecast of lower bond prices and the resulting higher interest rates. In addition, the survey showed a greater concern about inflation rather than the mortgage crisis. Another troubling factor is higher household inflation expectations over the next five years. It was reported that these inflation expectations have reached a thirteen year high. It is the increase in these inflation expectations that more than any other factor may lead the Fed to raise interest rates as the Fed does not want to see inflation expectations take hold.

See the links below.

CNNMoney.com: http://money.cnn.com/2008/06/10/markets/thebuzz/index.htm?postversion=2008061010

The New York Times:

http://www.nytimes.com/2008/06/11/business/worldbusiness/11stox.html?ref=business

Bloomberg.com:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aFhSf54NDYxk&refer=home