| STEVE H. HANKE | Steve H. HANKE |
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CONTRIBUTING EDITOR Professor of Applied Economics at the Johns Hopkins University & Columnist at Forbes magazine |
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The dollar and U.S. inflation |
In years past, the hot topic was Turkey’s sinking lira and high inflation. Today is a different story. Now it’s the dollar that’s sinking and U.S. inflation that is rearing its ugly head.
U.S. import prices rose by 10.9 percent last year. That’s the fastest yearly increase since records began in 1982. In addition, the most recent monthly data for various U.S. price indexes are most troubling. On a year-over-year basis, the consumer price and producer price indexes for November jumped to 4.3 percent and 7.2 percent, respectively. Even the Fed’s favorite backward-looking inflation gauge – the so-called core price index for personal consumption expenditures – has increased by 2.2 percent over the year (Nov. 06-Nov. 07) and has pierced the Fed’s 2 percent inflation ceiling.
Contrary to what the inflation doves have been telling us, inflation and inflation expectations are not well contained. The dollar’s sinking exchange value (a forward-looking price) signaled long ago that monetary policy was too loose and that inflation would eventually flare up. This, of course, hasn’t bothered the mercantilists in Washington. They espouse a weak dollar policy and have rejoiced as the dollar has shed almost 30 percent of its value against the euro over the past five years. For them, a maxi-revaluation of the Chinese renminbi against the dollar and an unpegging of other currencies linked to the dollar would be the ultimate prize. As the mercantilists see it, a decimated dollar would work wonders for the U.S. trade deficit. What nonsense! In open economies, ongoing trade imbalances are all about net saving propensities, not changes in exchange rates. Large U.S. trade deficits have been around since the 1980s without being discernibly affected by fluctuations in the dollar’s exchange rate. It’s time for the Bush administration to put some teeth in its “strong” dollar rhetoric. A stronger dollar will ensure that it retains its preeminent position as the world’s reserve, intervention, vehicle and invoicing currency. It will also provide an anchor for inflation expectations, something the Federal Reserve is anxiously searching for. The time is economically and politically propitious for coordinated joint intervention by the industrial countries to strengthen and put a floor under the U.S. dollar—as they have in the past during occasional bouts of undue dollar weakness. Indeed, America’s most important trading partners have expressed angst over the dollar’s recent decline. The president of the European Central Bank (ECB), Jean Claude Trichet, has expressed concern about the “brutal” movements in the dollar-euro exchange rate. Japan’s new Prime Minister, Yasuo Fukuda, has worried in public about the rising yen pushing Japan back into deflation. The surge in the Canadian “petro dollar” is upsetting manufacturers in Ontario and Quebec. OPEC is studying the possibility of invoicing oil in something other than the dollar. And China’s premier, Wen Jiabao, recently complained that the falling dollar was inflicting big losses on the massive credits China has extended to the U.S.
If the ECB, the Bank of Japan, the Bank of Canada, the Bank of England, and so on, took the initiative, the U.S. should cooperate. Joint intervention to strengthen and put a floor under the slumping dollar would insure that markets receive a strong signal that national governments have made a credible commitment.
This brings us to the world’s great currency bogeyman, China, and all the misplaced concern over its exchange rate. Given the current need to make a strong dollar policy credible, it is perverse to bash the one country that has done the most to prevent a dollar free fall. China’s massive interventions to buy dollars have curbed a sharp dollar depreciation against the renminbi. Forcing China into a major renminbi appreciation would usher in another bout of dollar weakness and further unhinge inflation expectations in the U.S. It would also send a deflationary impulse abroad and destabilize the international financial system.
In addition to preventing another dollar crisis, China, with its huge foreign exchange reserves (over US$1.4 trillion), has another important role to play. Once the major industrial countries with convertible currencies—led by the ECB—agree to strengthen and put a floor under the dollar, emerging markets with the largest dollar holdings—China and Saudi Arabia—must chip in by agreeing not to “diversify” into other convertible currencies such as the euro. Absent this agreement, the required interventions by, say, the ECB would be massive, throwing the strategy into question.
But cooperation is a win-win situation: the gross overvaluations of European currencies are mitigated, large holders of dollar assets are spared capital losses, and the U.S. escapes an inflationary conflagration associated with general dollar devaluation. For China to agree to all of this, however, the U.S. (and EU) must support a true strong dollar policy by ending counterproductive China bashing.
