A strong dollar and lower rates? Not all that good

A couple of good articles on Econbrowser I want to point you toward from recent days dealing with the always-nerdy but often-important issue of foreign exchange and interest rates.

The first is from UW Professor Menzie Chinn, who talks about the strengthening of the US Dollar over the last 8 months, and why that may not be as good for the economy as that connotation sounds.

The US trade deficit has shrunk considerably since its peak of 5.9% of GDP in 2005Q4. It was 3.1% of GDP as of 2014Q4 (second release). The non-oil trade deficit has exhibited a much smaller decrease; the 3.8% deficit has shrunk to 2.1% as of last quarter. Notice that the real value of the dollar, lagged two years, has an inverse relationship with the trade balance. Hence, eventually, it makes sense that the deficit will eventually deteriorate (relative to counterfactual) as a consequence of the recent appreciation....

As in previous instances, I rely on statistical models of trade flows, taking into account at a superficial level vertical specialization and heterogeneity. Imports depend on domestic GDP and the real value of the currency; exports depend on foreign economic activity and the real value of the currency. Since oil imports and agricultural exports are primarily denominated in dollars, I omit these flows from the calculations. In this paper, I find the long run (in a statistical sense) elasticity of nonagricultural exports of goods with respect to the real exchange rate is 0.690 (Table 2), and nonpetroleum imports of goods elasticity is 0.446 (Table 3). These estimates are obtained using dynamic OLS (DOLS), following Stock and Watson (1993). Assuming the 20% appreciation is sustained, then exports are about 13.8% lower than they otherwise would be, and imports about 8.9% higher.

Given that nonagricultural exports are 1349 billion Chained 2009$ (SAAR), and nonpetroleum imports are 1976 billion Chained 2009$ in 2014Q4, then such changes would be equivalent to 174 and 184 bn Ch.09$ at annual rates. This implies about a 2% decrease in the level of real GDP, relative to what it otherwise would be (assuming a multiplier of unity). Obviously, the impact of the 20% appreciation would take some time to affect flows, so the impact on GDP growth would be relatively small per quarter.

Simply put, the stronger dollar makes imports cheaper, which encourages more of them to come in, and lowers exports for US businesses. We may already be seeing some of that, as January 2015 had a drop of $3.7 billion in exports compared to January 2014, with very little change in overall imports to offset it. To boot, those exports figures were down $5.5 billion (around 4%) on a seasonally-adjusted basis from December 2014. That may be just a one-month blip, but with the dollar staying strong through the middle of March, lets see if February holds up with that trend.

Also on Econbrowser is James Hamilton from UC-San Diego, and he mentions last week's meeting of the Federal Reserve, which cheered markets by seeming to take a wait-and-see approach on raising interest rates off of its current near-zero level.

It’s also worth noting that the median FOMC “longer run” interest rate prediction came out at 3.75% from both the December and the March meetings, though the distribution of the individual “dots” from the latter has clearly drifted down. With a long-run inflation objective of 2%, that implies an equilibrium real interest rate of 1.5-1.75%. Compare that to the yield on a 10-year Treasury inflation-protected security that is now below 20 basis points.

All of which raises the question: does the Fed know something the market doesn’t, or vice versa? Tim Duy concludes “it is now clear the bond market is not moving toward the Fed; the Fed is moving toward the bond market.” But my answer to the question is: a little of both. Based on the historical evidence reviewed here I think it’s reasonable to expect an equilibrium real rate significantly above 0.2% and significantly below 1.5%. But given my own (and everyone else’s) uncertainty about exactly where the number is within that range, it makes sense for the Fed to wait a little longer before raising rates.

And as Menzie pointed out last week, international developments are leaving the Fed little choice. One important channel by which monetary policy can influence the Fed’s targets for output and inflation is through the exchange rate. A higher interest rate in the U.S. than in other countries means a stronger dollar. That makes it harder for the U.S. to export goods and makes imports more attractive, both of which mean a drag on U.S. GDP. And insofar as a stronger dollar means a lower dollar price for internationally traded commodities, it also takes us farther below the Fed’s 2% inflation target. When other countries are lowering their interest rates, that by itself tends to bring down U.S. output and inflation, and mitigates any argument for raising U.S. interest rates.

And note that the yield on the 10-year note has been diving over the last 2 1/2 weeks.

10-year T-bond closing yield
March 6 2.24%
March 23 1.91%

We're now closer to the low of 1.67% that we saw on Feb. 2 than the 2.24% high of March 6. But the strong dollar would indicate that interest rates should go up (because it makes foreign investors less likely to buy our more expensive debt). So does that mean the dollar goes down to match the lower interest rates, or the dollar stays strong, and rates eventually slide up? Or is there a third option, that shows that the economy is slowing down and that there's more slack in the labor market than the Fed originally thought, so they have to keep things low and keep the cocaine party on Wall Street rolling.

I think we're going to find out pretty soon, but there's been an odd push and pull in the currency and debt markets in recent weeks.