The Wall Street Journal, the Dollar and the Fed

Today’s Wall Street Journal editorial, “The Buck Stops Where?” is the latest in a long series of editorials and articles suggesting the Federal Reserve has been “reckless” to cut interest rates on bank reserves. This story relies heavily on some questionable arguments about the dollar’s exchange rate.

Here are some quotes from the editorial followed by my comments:

1. “The flight from the dollar has made U.S.-based investments less attractive at a time when the U.S. financial system urgently needs to raise capital.”

   That is almost backwards. It now costs fewer Euros or yen to buy U.S. shares or build U.S. plants than it did a few months ago, which makes U.S. investments more attractive to foreigners, not less attractive. It is true, however, that if the dollar were expected to fall sharply in the future, then risk of exchange rate losses might discourage foreigners from buying dollar-denominated assets and also encourage U.S. investors to buy foreign securities.

2. “If the dollar had merely retained its value against the euro, oil would be in the neighborhood of $70 a barrel. Dollar weakness explains a large part of the oil price surge.”

   The reason a lower dollar makes oil prices rise is that it makes oil cheaper than it would otherwise be in euro, so Europeans buy more oil than they otherwise would – bidding-up the price (at least in dollars). We can’t be sure what would have happened to oil prices if the Fed had kept interest rates on bank reserves high enough to maintain the dollar’s value against the euro, because higher U.S. interest rates would have had some adverse effects on the world economy (and therefore on industrial demand for energy). If the euro had been stabilized by cutting ECB interest rates, by contrast, the effect on oil prices would have been much different. The oil price is a ratio of barrels to dollars, which means it is partly real and partly monetary.

3. “Exports in goods are being more than offset by the rising cost of oil imports.”

   Actually, the U.S. current account deficit in fourth quarter was down 12.7% from a year before. Incidentally, purchases of U.S. government securities by foreign central banks were reduced by $148.8 billion last year, while private foreign investments in Treasuries rose by $202.1 billion.

4. “Import prices have surged nearly 14% in the last year.”

   Import prices were up by 13.6% in the 12 months ending in February only because the price of petroleum imports was up by 60.9%. The price of all other imports was up 4.5%. While it makes some sense to blame rising import prices on dollar weakness, it does not make sense to suggest that petroleum prices are uniquely affected by the dollar, unlike most other imports.
   
   There is also some reverse causality--with rising oil prices contributing to a lower dollar and not just the other way around. Rising commodity prices lift the exchange rates of commodity-exporting countries like Canada and Australia, which shows up as a drop in the trade-weighted U.S. dollar.

David Malpass of Bear Stearns is an excellent economist who has supported a strong dollar in several Journal op eds. But Malpass does not argue, as the editorial page does, that a weaker exchange rate is necessarily inflationary. Indeed, one of the graphs in David’s December 6 forecast was aptly titled, “Trade-weighted dollar not well-connected to CPI inflation.” Even using 3-year trends, there’s virtually no connection.

On March 14, the Journal’s “Ahead of the Tape” column argued that the Fed is wrong to focus on core inflation, because “inflation is on the rise and energy and food have a lot to do with it.”

Should the Fed raise interest rates when world oil prices go up and lower interest rates when oil prices fall?

That is, after all, what it means to say the Fed should base policy on “headline” inflation, including energy prices (and the impact of ethanol subsidies on food prices).

While he was an academic researcher, Ben Bernanke showed that central bank reactions to oil prices have caused or aggravated virtually every postwar recession.

Recessions eventually cause oil prices to fall and central banks to ease aggressively – years after the recession is over (as in 2003-2004), as I noted in “Interest Rates and Dollar Fundamentals” (WSJ Nov. 15, 2007)

What is different this time is mainly a matter of timing – the Fed easing before recession rather than long after. What also appears different, so far, is that the Fed is acting alone, which largely explains the euro’s recent strength. Yet the ECB has always followed the Fed, after many months, and probably will again.

The Fed may be at risk of overdoing it, but making that case requires looking at some historical variables (or a model, like John Taylor’s) that have a decent track record for predicting inflation.

The trade-weighted dollar has been falling since February 2002, and the price of gold has risen nearly as long. If exchange rates or gold prices could generate reliable forecasts of inflation, then we should have seen escalating inflation for the past six years.