Is a lower US dollar good news?

Lower US dollar Federal Reserve Bank Australia
The US Federal Reserve’s move to drive its dollar down could boost other developing world economies at first, but analysts warn it could harm European growth.

All around the world, central banks are watching the US Federal Reserve very closely after it successfully drove down the US dollar with its more tolerant view of inflation.

As economies everywhere struggle to emerge from the long recession shadow cast by the COVID-19 pandemic, the Fed’s action of allowing inflation to run higher for longer is giving the US an important competitive advantage.

A lower currency improves a country’s export performance and discourages imports, which also boosts local jobs and stimulates the domestic economy.

However, cutting a currency can have other effects such as sparking or worsening a trade war and encouraging retaliatory actions.

In the case of a lower US dollar, the stimulus of a lower currency is more widespread than for any other country, given that many commodities are priced in US dollars.

A lower US dollar is also seen to be stimulatory for much of the developing world, at least initially.

Fed decision now seen as crucial

At first, the Fed decision on 27 August was seen as relatively benign, allowing the central bank to use average inflation targeting so that it could overshoot its target after downturns.

However, the new policy settings would also allow the jobs market to run hotter to boost employment – particularly among those on lower incomes – with rate hikes coming in much later as the economy recovers.

What is causing concern for other central banks is not just that this could usher in a new era of central banks pursuing broader social, rather than economic, priorities but also, what the effect could be on the US dollar and their own currencies.

So far, the effect is clear – it has led to a lower US dollar versus many other currencies including the big ones of the Euro and the Yen, but also against a big basket of currencies including the Australian dollar.

US dollar has fallen after the decision

After rallying hard due to its safe haven status to reach three-year highs back in March, the US dollar is now around 10% lower, with no shortage of analysts predicting a steady fall into Christmas.

If you are a central banker sitting in Japan or Europe, a lower US dollar is an alarming prospect because it makes your country’s exports less competitive and harms employment – the opposite of what you want to achieve, particularly with the economy already in recession due to the pandemic.

However, with Japan and Europe already holding interest rates below zero and running out of ammunition to drive their ultra-easy monetary policy settings, there are few easy answers.

Japanese and European central banks also face political opposition to providing further stimulus.

Lower US dollar will harm European growth

Already analysts have said the current lower US dollar will cut European economic growth by up to 0.4% at a time when every tiny bit of economic growth is needed.

It is possible, but unlikely, that Europe including Britain, as well as Japan, could simply copy the US inflation averaging set up; but the basic, take home message is that they will probably need to find a way to stimulate their economies further, perhaps through more government spending.

RBA also being watched

Here in Australia, our currency is linked more closely to commodity prices, with interest rates also playing a big role.

Our Reserve Bank has also drawn international attention because it is trying to exert what is called yield curve control – effectively targeting a certain interest rate for three-year Australian Government Bonds and stepping into the market to buy them if they rise above a yield of 0.25%.

It is a relatively “cheap’’ policy because once the market accepts that the RBA will step in and buy bonds, it usually trades under that rate so there is no need for an enormous number of bond purchases.

The Reserve Bank also controls the overnight rate, but this has fallen well below the 0.25% cash rate to around 0.1% as the yield curve control puts downward pressure on short-term rates – along with the sharp increase in domestic savings.

Yield curve control hasn’t stopped the Australian dollar from rising strongly against the US dollar since March, but it is being closely watched by other central banks as an extra tool they might consider adding to their arsenal.

The US Fed last used yield curve control in the 1940s to manage the huge debts left after the Second World War.

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