Interest Rates and Dollar Fundamentals

November 15, 2007 • Commentary
This article appeared in The Wall Street Journal on November 15, 2007.

Is the dollar down or is the euro up? It is the same thing viewed from different sides, of course. Yet the topic is too often viewed from just one side. Looking at the dollar alone, many economists blame the Fed for lowering interest rates. Viewed from the other side, however, one might wonder why other central banks have not lowered their interest rates.

Rising currencies are not necessarily a sign of strength. The U.S. dollar rose sharply before and during the recession of 2001. The trade‐​weighted index of the dollar’s value against 26 currencies rose 10.5% from March 2000 to January 2002, as the stock market and economy tumbled.

A graph in the Aug. 5–11 issue of The Economist showed that, “countries whose currencies have gained most [against the dollar] are high interest‐​rate economies, such as Turkey, Brazil and New Zealand, commodity producers, such as Canada, or a mixture of both, such as Australia.”

Central‐​bank interest rates are 16.75% in Turkey, 11.25% in Brazil, 8.25% in New Zealand, 6.75% in Australia and 5.75% in the U.K. High interest rates may prop up a currency for a while by attracting international “hot money.” But super‐​high interest rates, like those in Turkey and Brazil, are typically a symptom of inflation‐​prone monetary policy, requiring a high risk premium to bribe investors to hold that country’s IOUs. In any case, high interest rates are certainly not something most Americans would envy or hope to emulate.

The spectacular rise of the Canadian dollar was more closely tied to the price of oil than to interest rates, although the Bank of Canada did raise interest rates in July, just before the Fed began nudging rates down.

While prices of oil and gold were soaring, exporters of oil and gold such as Canada could trade their wares for more U.S. technology and services. Such improved “terms of trade” typically raise the global demand for the assets of commodity‐​producing countries and thereby raise their currencies.

Other commodity exporting countries, such as Australia and to some extent the U.K., also see their currencies rise whenever the price of their exports rises faster than the price of their imports. Trade deficits have nothing to do with it. Australia’s current account deficit is a bit larger than that of the U.S., as a share of GDP, and Britain’s deficit is not much smaller.

Currencies of commodity exporters likewise fall when commodity prices fall. When the price of oil fell in early 1986, late 1998 and 2001, the Canadian dollar fell substantially, even though central‐​bank interest rates were higher in Canada than in the U.S.

Many currency and commodity traders have recently made leveraged bets that prices of oil and gold could only go higher, but the expression “trees don’t grow to the sky” does not just apply to stocks.

What about the euro? Interest rates set by the European Central Bank (ECB) are now about the same as in the U.S. But that is something quite new. In June 2006, the euro discount rate was only 3.75% while ours was 6%. Today, they are both at 5%.

Until recently, the ECB had pegged its interest rate on “main refinancing operations” (MRO) as much as 2.25 percentage points below the equivalent U.S. fed‐​funds rate. That gap between U.S. and euro interest rates widened in 2005 and early 2006. Unsurprisingly, the euro then fell to 1.195 per dollar from November 2005 to March 2006 — down 16% from its level at the end of 2004.

The Fed stopped raising rates after June 2006, but the ECB continued to push rates higher. As a result, the gap between U.S. and euro interest rates first narrowed and then vanished as the Fed eased. Unsurprisingly, the euro rose.

The euro’s recent rise involved betting on the expectation that the Fed will soon cut interest rates again, but also that the ECB will not follow suit. Yet the ECB has always followed the Fed’s interest‐​rate moves, albeit quite slowly. The ECB did not begin reducing rates until May 2001 — five months later than the Fed. And the ECB did not put rates above 2% until December 2005 — a year later than the Fed.

In past episodes of rising oil prices — 1974, 1980 and 2000 — all major central banks raised interest rates in unison. That always ended in a world recession, which was belatedly followed by deep cuts in central bank interest rates. After the oil spike of August‐​November 1990, when the fed‐​funds rate was above 8%, the Fed failed to reduce interest rates significantly until a year after the recession ended.

Those calling for higher central‐​bank interest rates when oil prices rise should realize that such policies have, in the past, resulted in interest rates of 1%-2% two or three years later (arguably too low and too late), after global industrial slumps slashed the price of oil.

This time, the Fed was first to jump off that rusty old bandwagon, unilaterally. That obviously affected exchange rates. However, this does not necessarily mean other central banks have been pursuing a wiser course.

There are two sides to every exchange rate. Perhaps it is time for the other side — notably, the central banks of Europe, Canada and the U.K. — to take their turn at reducing interest rates, even if the Fed sits this one out.

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