The High-Dollar Blues
Introduction: The Challenges of an Unbalanced Global Economy
Six years past the most destabilizing economic and financial crisis since the 1930s, both strength and balance remain absent from the global economic growth picture. While the crisis in the Eurozone has vacillated in intensity, it remains a significant problem for the world outlook. Absent the stimulus of high commodity prices, economic performance in Latin America is sluggish, with Brazil, the largest Latin American economy, in a recession. China’s slowdown, while a necessary condition for much-needed structural change, has nonetheless progressed to the point of worrisome global risk. U.S. growth may be volatile and subpar by historical standards but is nonetheless sufficient to make the nation the strong player in a weak world.
In these post-crisis years, central banks outside of the U.S. are worried about slow growth as well as deflation, an actual fall in the average price level of an economy. As Japan’s 1990s and early 2000s experience has shown, deflation is damaging in that it can keep an economy trapped in a lengthy cycle of stagnation. Increasingly, without stating so directly, global monetary policymakers appear to be actively or passively targeting a weaker currency as a means of strengthening growth through export demand acceleration and pulling away from deflation through higher import prices.
Every country, however, cannot have a lower currency during the same period. For global investors facing a world of deflation risk and central bank acquiescence in depreciation, the currency of the relatively strong player, the U.S. dollar, becomes a hedge, similar to the role that gold played in past periods of strife. The dollar is currently viewed as the monetary asset most likely to either hold or increase its value during the current period. As a result, the broad trade-weighted dollar appreciated by nearly 10% in relative price-adjusted terms between April 2014 and April 2015.
U.S. manufacturers, already burdened by weak demand for their exports and an uncertain climate for domestic U.S. equipment investment, are now grappling with a significant issue of global price competitiveness. This article uses a historical perspective to consider the implications of today’s dollar challenge for the U.S. factory sector. A look ahead is offered in the concluding remarks.
The Long History of the Broad Dollar
Figure 1 shows the history of the broad dollar index extending back to the early 1970s. This index is calculated as the trade-weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners.The index weights change over time and are derived from U.S. export shares and U.S. and foreign import shares. The index is shown in both nominal and price-adjusted (real) terms. As inflation (excluding food and energy prices) fell dramatically from the 1980s into the 1990s, the gap between the real and nominal broad dollar narrowed.
The volatility in the broad dollar is well demonstrated by both measures. The real index experienced two pronounced cycles of appreciation and depreciation in the post-1973 period, one beginning in the early 1980s when the U.S. economy was weak and troubled and another beginning in the mid-1990s when U.S. growth was quite strong.
The magnitude of the recent dollar appreciation has yet to even approach what was seen in the early 1980s and mid-1990s. Instead, it can be argued that the spike in the greenback is something of an expected rebound from the fairly dramatic depreciation that began after the early months of 2002.
Figure 1 – Broad Dollar Index
Figure 2 shows the four-decade history of the real and nominal major currencies index, a weighted average of the foreign exchange value of the U.S. dollar against a subset of currencies in the broad index that circulate widely.The weights are identical to those used to calculate the broad index. The real and nominal dollar indices for the major currencies move very much in tandem. Qualitatively, the historical picture is much the same as for the broad index. While the current spike is substantial, it has yet to match that of the early to mid-1980s or the mid- to late 1990s.
Interestingly, the nominal index exhibits something of a secular downward trend in the period since the early 1970s, with lower peaks and lower valleys. If this is any kind of a predictive indicator, periods of stress might be somewhat counterbalanced by a longer-term propensity toward a competitive dollar.
Figure 2 – Major Currencies Dollar Index
The Dollar’s Relationship to Key Currencies
Further perspective on today’s dollar challenge can be obtained by examining its long history against individual key currencies. A mix of secular moves and short-term volatility characterizes the greenback’s relationship to a number of currencies of major trading partners. For example, between 1976 and 2002, the Canadian dollar experienced a long decline against the U.S. dollar (Figure 3). The post-2002 turnaround was dramatic, bringing the Canadian dollar above parity with the U.S. dollar by October 2007 for the first time since November 1976.
The subsequent plunge of the Canadian currency was part of a global move into the U.S. dollar in the wake of world financial panic. The depreciation since the most recent peak in 2012 most likely reflects some firming in U.S. economic growth relative to other major regions as well as specific concerns about prospects for the commodities-exporting Canadian economy amidst slower Chinese and global growth.
Figure 3 – U.S. Dollars Per Canadian Dollar
The post-2008 volatility of the euro against the dollar (Figure 4) reflects vacillating degrees of concern about the rolling debt and growth crises plaguing the Eurozone in recent years. As the European Central Bank has become more aggressive in attempting to stabilize the region, the currency has reacted with less volatility and more certainty, falling from $1.38 in December 2013 to $1.12 by April 2015.
Figure 4 – U.S. Dollars Per Euro
After the seemingly secular rise in the yen from the 1980s to the 1990s (Figure 5), the Japanese currency’s path has been one of considerable volatility, coming to a recent peak in October 2011, just before dramatic quantitative easing from the Bank of Japan—an effort to stir the long-moribund Japanese economy—brought the currency down to levels last seen in mid-2007.
Figure 5 – U.S. Dollar Per Japanese Yen
Manufacturing Impacts of a Rising Dollar
The authors of an articleLinda S. Goldberg and Keith Crockett, "The Dollar and U.S. Manufacturing," Current Issues in Economics and Finance 4, no. 12, Federal Reserve Bank of New York, November 1998, www.ny.frb.org/research/current_issues/ci4-12.pdf. published in November 1998, a period of dollar appreciation, argue that a rising greenback can affect U.S. manufacturing in two ways. A higher dollar pushes up the price of U.S. goods in export markets and gives foreign producers a competitive edge in domestic pricing.
The authors note cost impacts as well. U.S. manufacturing firms are increasingly relying on foreign equipment and components in producing their goods. When the dollar rises, the cost of imported inputs falls. Thus, a rise in the dollar has revenue costs on the export side but input cost benefits on the import side. The balance, at least to some extent, depends on the industry, with the decline in profits appearing to be sharper for industries that rely more heavily on export markets and have more labor-intensive production.
The international exposure of U.S. manufacturing is a critical framework for assessing the effects of a rising dollar. For this purpose, the authors use a measure of net external orientation, the share of the total revenue of an industry that is derived from exports less the share of its total spending that is derived from imports. The authors report that between 1984 and 1995, the net external orientation of the U.S. manufacturing sector as a whole more than doubled, increasing from 1.9% to 5.2%. To a large extent, this reflects the rapid growth of the export dependence of U.S. producers.
Somewhat different calculations, undertaken for this article, confirm the continually rising exposure of U.S. manufacturing to global trade. Figure 6 shows goods exports and goods imports as a share of U.S. manufacturing value-added. With the exception of 2008 and 2009, a period when global trade contracted, both have been on a significant upswing. Between 2000 and 2013, goods exports as a share of manufacturing value-added rose from 51.3% to 77%, a 25.7 percentage point increase. The goods import share rose even more, from 80.5% in 2000 to 113.5% in 2013, a 33 percentage point increase.
Figure 6 – Exports and Imports of Goods as a Percent of Value-Added in Manufacturing
Figures 7 and 8 illustrate the trends in the same metrics for durable goods and nondurable goods manufacturing. The story for these broad sectors is the same as for manufacturing as a whole. Between 2000 and 2013, the durable goods export share increased by 26 percentage points and the import share increased by 36 percentage points. For nondurable goods, the export share rose by 28.8 percentage points and the import share rose by 32 percentage points.
Figure 7 – Exports and Imports of Durable Goods as a Percent of Value-Added in Durable Goods Manufacturing
Figure 8 – Exports and Imports of Nondurable Goods as a Percent of Value-Added in Nondurable Goods Manufacturing
The Question of Pass-Through: A Key Study
The link between currency fluctuations and import prices, commonly referred to as “pass-through,” is critical to the ultimate impact of a dollar appreciation and has been a subject of intense study and debate. An April 2005 research paper from the Board of Governors of the Federal Reserve offers noteworthy evidence and conclusions that are generally, if not completely, agreed upon.Mario Marazzi et al., "Exchange Rate Pass-through to U.S. Import Prices: Some New Evidence," International Finance Discussion Papers, no. 833, April 2005, www.federalreserve.gov/pubs/ifdp/2005/833/ifdp833.pdf. The authors estimated a range of equations relating the exchange rate to U.S. import prices. They document a large decline in the pass-through coefficient over time. They note that the decline is robust to alternative specifications of the model used for empirical testing.
While admitting the source of the pass-through decline is difficult to pin down, they offer relevant inferences. The share of industrial supplies fell from one-third of core goods imports in the 1970s to less than one-fifth at the time of the 2005 study. Industrial supplies are commodity-intensive and display high pass-through. The authors also point to evidence that export prices for the newly industrialized economies in Asia and Canada have shown increased sensitivity to exchange rate changes, consistent with declining pass-through to U.S. import prices. Low pass-through to import prices denominated in the importer’s currency implies that export prices denominated in the exporter’s currency are very sensitive to the exchange rate.
Tentative evidence of weakening pass-through can be found in Figure 9, which shows an index of U.S. import prices (excluding petroleum). In the current period, the dollar’s appreciation has had some impact, but the effect has certainly been muted relative to a volatile history.
Figure 9 – Index of U.S. Import Prices (End Use), Excluding Petroleum
Today’s Situation and a Look Ahead
Thus far, the current episode of dollar appreciation is small relative to history. Nonetheless, the increasing global exposure of the U.S. manufacturing sector and the frustrating persistence of weak world demand likely make the 2015 greenback challenge for U.S. manufacturers painfully comparable to previous dollar spikes. While there is probably some benefit on the imported input side, the general decline in the pass-through of currency fluctuations to import prices makes this less of a compensating factor.
The dollar appreciation of the past year appears geographically broad-based. The graphs presented in this article show the recent significant declines of the Canadian dollar, the euro, and the Japanese yen. The U.S. currency is unlikely to fall back measurably from its current levels as long as markets perceive that U.S. economic performance is the strongest and most stable in the world.
Lately, there have been some challenges to the U.S. economic picture. U.S. data for the first quarter of 2015 were disturbing, although some of the weakness can be attributed to transitory factors. Meanwhile, there appears to be a bit of strengthening in the Eurozone.
Barring any significant surprises, markets will continue to believe that the U.S. Federal Reserve will be the first major central bank in the world to tighten policy, even if the tightening is now somewhat delayed. A belief in imminent Fed tightening favors dollar strength.
But the dollar will fall at some point. History shows great volatility in currencies—and there is no reason to believe that this will change.