The U.S. dollar index has steadily declined over the past few months. This has generated much market commentary, with many noting the soaring gold prices (and bitcoin) as suggesting that the death of the dollar is imminent. But depreciating the dollar in a global recession is just standard, and predictable, macro policy. In this post I’ll walk through the rationale for depreciating the dollar, how that is being accomplished, and whether that means the dollar will lose its reserve currency status.
Dollar depreciation a good thing for the U.S. (and the world!)
Textbook macro policy suggests that a depreciating currency helps in an economic recovery by increasing exports and decreasing imports. This gives a boost to export industries, and encourages consumers to switch from importing increasingly expensive exports to buying domestic goods. Both factors are positive for domestic growth. However, there are two constraints to depreciating a country’s currency that has to be taken into account: inflation and foreign retaliation.
Inflation arises because the goods a country imports may become more expensive. For example, a weaker dollar means cars imported from Japan and priced in Yen are now more expensive. Most countries operate in an inflation targeting monetary framework, so currency depreciation is constrained by its impact on domestic inflation.
Currency depreciation essentially “steals” global demand from foreign countries, so the home country grows via exports at the expense of others. For example, a depreciating dollar may help U.S. manufactured cars appear cheaper than cars manufactured in Japan. In the context of a global recession, the U.S. is growing by taking a bigger share of a shrinking global pie. This obviously upsets foreign countries, and risks their retaliation through their own currency depreciation or tariffs.
However, the dollar’s unique role as a global reserve currency moderates the two aforementioned constraints. The U.S. dollar is essentially the currency of global commerce, where over 50% of international trade is invoiced in dollars. (For more info, see this seminal paper on the topic by Gopinath, now Chief Economist at the IMF). It’s important to understand that it’s not just foreign countries trading with the U.S. that invoice in dollars, but trade between two non-U.S. countries is also generally invoiced in dollars.
When the U.S. imports goods, the goods are usually invoiced in U.S. dollars, and they are not frequently renegotiated (prices are ‘sticky’). This means that a cheaper U.S. dollar has a limited impact on domestic inflation. A 10% weaker dollar would have a limited impact on import prices, because the goods imported are also priced in sticky dollar prices. In contrast, if Turkey depreciated its currency by 10% then its imports (which are largely priced in dollars) would be 10% more expensive, and the inflationary impact would be palpable.
The corollary to the dollar’s status as the currency of global trade is that a weaker dollar is positive for global growth. Foreign companies throughout the world that are involved in global trade use dollar debt in their operations. When the dollar depreciates, that dollar debt becomes cheaper from the perspective of their home country currency. A weaker dollar improves their financial position, improving their capacity to borrow. (See this paper from the BIS for more information). This economic benefit makes a weaker dollar welcome throughout the world, especially in emerging markets.
How Does the Fed Depreciate the Dollar?
A central bank has a lot of influence on it’s currency through its control of interest rates and ability to print money. In theory, raising (lowering) interest rates causes a currency to appreciate (depreciate). Printing more money can also depreciate is currency. In practice, currency markets are largely driven by sentiment where a central bank affects its exchange rate simply through communications. The market understands that a central bank has a lot of tools to back up its words, so it will respond accordingly. For example, the Swiss National Bank instantly depreciated its currency in 2011 by committing to print unlimited Francs to prevent the Franc from appreciating below 1.2 Francs to the Euro.
The Fed controls short term interest rates by adjusting the interest it pays on bank reserves, and the interest rate it offers at its Reverse Repo Facility. It influences longer term interest rates through quantitative easing – by buying Treasuries it pushes the price of Treasuries higher (yields lower).
There are two mechanisms through which lower rates depreciate the dollar: relative value and credit creation. When U.S. rates are lowered, then on the margin U.S. investments become less attractive. Capital moves out of the U.S. to other countries, and in the process causes the dollar to depreciation. When U.S. rates are low, there is also more demand for dollar credit. The newly created dollars are spent, sometimes to buy goods or financial assets in foreign currencies. For example, a Mexican company could take advantage of lower USD rates to borrow in USD to fund investments in Mexico denominated in pesos. USD is created through loans, then sold for Mexican pesos.
The Fed can further subsidize dollar credit creation by itself explicitly backstopping the financial system through its lending facilities. For example, the Fed stands ready to print unlimited dollars and lend them to domestic banks (Discount Window) and foreign banks (via the FX swap facilities). This takes liquidity risk off the table for many market participants, further reducing the pricing and thus increasing the availability of dollar credit.
Is the Dollar losing its reserve status?
Nope – there simply isn’t any currency to take its place. Nothing even close.
But more importantly, a weaker dollar is positive for global growth and encourages the on-going adoption of the dollar. Emerging markets will further increase their dollar borrowing since dollars borrowing rates are lower than their domestic currency rates (for example, Chinese and Mexican 10-year yields are around 3% while U.S. Treasuries are around 1%), and a more widely accepted currency.
The dollar is ironically much more likely to lose its reserve status if it were to strengthen significantly, rather than weaken significantly. A strong dollar would wreck havoc on foreign balance sheets and global growth, eventually forcing the world to move away from a dollar standard. But a weak dollar further ingrains the USD into the global economy.