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 Currencies
V


A weak economy and an active Federal Reserve have driven the dollar
down since June. Will that last?

›ug 12th 2010

THREE months ago, when Europe¶s debt crisis had markets panicking about sovereign risk,
it seemed that all roads led to the dollar. The greenback was rising against the other big
global currencies, the yen, pound and euro. Its role as the world¶s reserve currency seemed an
inestimable advantage when investors were unsure where they could safely park their cash.
Within the rich world, ›merica¶s economy looked the best of a bad bunch. The stage seemed
set for a dollar rally.
 

How quickly things have changed. On ›ugust 11th the dollar fell to a 15-year low against the
yen of ¥84.7. It perked up against the euro to $1.29, though that was still much weaker than
the $1.19 it reached in early June when euro-revulsion was at its worst (see chart 1). The
ground the greenback has lost in recent weeks owes to a run of weaker data about the
economy, not least on jobs (see box on the next page). On ›ugust 10th the Federal Reserve
conceded that the recovery would probably be slower than it had hoped. The Fed kept its
main interest rate in a target range of 0-0.25% and stuck to its creed that rates would need to
stay low for ³an extended period´. In addition the central bank said that it would reinvest the
proceeds from the maturing mortgage bonds it owns into government bonds to prevent its
balance-sheet (and thus the stock of ready cash) from gradually shrinking.

This modest change in Fed policy was widely expected. It signalled concern about the
economy while stopping short of panic measures. That did not stop stockmarkets from
slumping the day after the Fed¶s statement²perhaps because investors had hoped the central
bank would go further and commit itself to a fresh round of asset purchases, or perhaps
because they were unnerved by the Fed¶s more cautious tone on the economy. But the Fed¶s
shift still seemed to confirm that it is more minded than other central banks to keep its
monetary policy loose, a perception that has contributed to the dollar¶s slide and helped
›merica¶s exporters. The day before the Fed¶s decision, the Bank of Japan kept its monetary
policy unchanged. The European Central Bank (ECB) has allowed short-term market interest
rates to rise as it withdraws emergency liquidity support from the banking system.

Events in ›merica do not determine the dollar¶s fate: exchange rates have two sides. The
euro has bounced back since June in part because markets are more confident that Europe has
got to grips with its sovereign-debt problems. The currency¶s strength also reflects a stronger
economy. Figures due out after p

went to press were expected to show that the
euro area¶s GDP grew a bit faster than ›merica¶s in the second quarter, thanks largely to
booming Germany. But the problem of sluggish growth in the euro zone¶s periphery has not
gone away. › strong euro amplifies the lack of export competitiveness in Italy, Spain, Greece
and Portugal. That is one reason why many analysts think the euro is likely to weaken again.
 

The yen¶s rally, in contrast, may have further to run. It is trading against the dollar at levels
last seen in the aftermath of the peso crisis in the mid-1990s, when the yen had greater claim
to being a haven from troubles elsewhere. But the yen¶s renewed strength may not be quite as
painful for Japan¶s exporters as that implies. Years of falling prices in Japan combined with
modest inflation elsewhere mean the real effective exchange rate is below its average since
1990 (see chart 2). Because Japan¶s wages and prices have fallen relative to those in ›merica
and Europe, its exporters can live with a stronger nominal exchange rate.

What needs explaining, then, is not why the yen has strengthened recently but why it was so
weak before. Kit Juckes of Société Générale reckons that the low yields on offer in Japan
provide most of the answer. ³The yen is under-owned because Japan had by far the lowest
interest rates in the world,´ he says. But now falling bond yields in ›merica, as well as in
most of Europe, have made Japan a less unattractive place for investors to put their money.
The more that the rest of the rich world resembles Japan, the less reason there is to shun the
yen. There are even stories that China has been buying Japanese bonds as part of its effort to
diversify its currency reserves away from the dollar.

Such interest may not be entirely welcome in Japan. › cheap currency is especially prized
now, when aggregate demand in the rich world is so scarce and exports to emerging markets
seem the best hope of economic salvation. Japan¶s finance minister has complained that the
yen¶s recent moves are ³somewhat one-sided´. That kind of talk has spurred speculation that
Japan¶s authorities may soon intervene to contain the yen¶s rise. But such action would spoil
the rich world¶s efforts to persuade China to let its currency appreciate. It is perhaps more
likely that the Bank of Japan and the ECB will follow the Fed¶s lead in extending (albeit
modestly) its quantitative easing²or risk a rising exchange rate.

The battle for a cheap currency may eventually cause transatlantic (and transpacific) tension:
not everyone can push down their exchange rates at once. For now, though, the dollar holds
the cheap-money prize.

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