Ramon Moreno

English

Research Papers in Economics

FRBSF WEEKLY LErreA
December 2, 1988
The Baffling Dollar
The dollar's behavior in 1988 has mystified most
observers. Despite an external deficit of 304 per-
cent of Gross National Product (GNP) in 1987,
the dollar was largely stable from January to May
1988, and then started appreciating sharply in
the middle of June. By late September, the dollar
had appreciated more than 10 percent over its
levels in May, and close to levels last reached
during the period of dollar appreciation in the
summer of 1987. Since then, the dollar has
depreciated sharply, particularly following the
release of u.s. trade data in the middle of
October.
The relative strength of the dollar earlier this year
is particularly perplexing because, contrary to
the belief of many observers, it does not appear
to be explained by a rise in nominal or real U.s.
interest rates relative to those abroad. In fact,
the differential between nominal dollar- and
deutschemark-denominated eurocurrency inter-
est rates fell from 3.9 percentage points in May
to about 3.3 percentage points in August and
September even as the value of the dollar relative
to the deutschemark appreciated sharply. Also,
research by the Federal Reserve Bank of San
Francisco indicates that the real appreciation of
the dollar in 1988 cannot be explained by differ-
entials in long-term real interest rates.
This Letter discusses two alternative explanations
for the dollar's strength that have been offered by
a number of observers: (1) a vigorous expansion
led by an investment boom increased confidence
in the outlook for the u.s. economy and shifted
demand towards u.s. dollar assets; and (2) news
of improvements in the merchandise trade bal-
ance led markets to conclude that the dollar had
fallen enough to guarantee a sustainable external
position for the u.s.
. A vigorous expansion
One possible reason for the dollar's recent
strength is optimism about the outlook for the
u.s. economy, due to a robust and unusually
long expansion. In particular, a number of influ-
ential commentators have argued that a more
favorable investment environment in the 19805
has produced an "investment boom" that has
stimulated foreign demand for U.s. dollar assets,
thus contributing to the strong dollar and ex-
ternaldeficits in the 19805.
In this view, an investment boom was produced
by an improvementin the investment environ-
ment in the U.s. in the 1980s associated with a
rise in the after-tax return on capital. A Federal
Reserve Bank of San Francisco study estimates
that as a result of the 1981 Tax Act, the effective
tax rate on equity-financed equipment invest-
ment fell from 13 percent in 1980 to a low of one
percent in 1985. (As a result of further legislative
changes ithas since risen to 14 percent in the
first half of 1988.) The tax rate on investment in
structures declined from 62 percent in 1980, to
39 percent in 1985, and to 29 percent in the first
half of 1988.
Thus, according to this argument, lower tax rates
have probably increased the profitabilityof
investment in the U.S. and spurred economic
growth, contributing to the demand for U.s.
dollar assets and to the tendency for the dollar
to strengthen in the 1980s.
Recent indicators of U.S. economic performance
provide some support for this argument, as in-
vestment has expanded strongly during this
expansion. The real share of gross (including de-
preciation) investment in GNP averaged 17.4
percent between 1983 and 1987, about the same
as in the two expansions in the 1970s, even
though real interest rates have been much higher
in the 1980s compared to the 1970s. In addition,
unlike in the two earlier expansions, the invest-
ment ratio has not fallen off sharply after reaching
a peak in 1984. This suggests that the gross ac-
cumulation of capital stock associated with the
present expansion is larger than at any period
since the 1960s.
Moreover, the pace of investment spending
picked up in 1987 and 1988. Nonresidential in-
vestment spending grew nearly nine percent inFRBSF
1987, and close to 11 percent in the first half of
1988. The increase in investment spending con-
tributed to growth in U.s. GNP in 1987 and 1988
that is well above the two to three percent long-
run potential rate. With the exception ofJapan,
this growth has also exceeded that of its major
industrial trading partners.
However,there are two difficulties with the ex-
planation that an. investment boom mayhave
contributed to a strong dollar. First, some ques-
tion whether the current growth in investment
really qualifies as a boom .. Presumably, a boom
implies that domestic and foreign investors
would not only replace existing capital stockbut
increase the rate at which they add capital stock
in order to take advantage of improved invest-
ment opportunities in theUS. This, in turn,
would imply an increase in the share ofnet (of
depreciation) investment in national product.
Instead, the ratio of net investmentto NetNa-
tionaI Product (NNP), averaged 6.3 percent in
1983-87, belowthe average of 8.4 percent for
the two expansions in the 1970s.
A second difficulty is that the relationship be-
tween u.s. investment spending and fluctuations
in the value of the dollar is not very strong. For
example, itis not clear how an investment boom
can explain the steep dollar depreciation from
1985 to 1987, or the sudden drop in the dollar
after October 1988.
Improvements in the trade balance
If an. investment boom cannot fully explain the
dollar's recent behavior, perhaps the delayed re-
duction in the u.s. trade deficitcan. Until this
year, a number of observers questioned whether
the dollardepreciation since 1985wouldhelp to
correct the external imbalance.in theus. econo-
my. Even after the dollar began depreciating in
1985, the nominal merchandise trade deficit
continued to rise-from $100 billion (annual
rate) in the first quarter of 1985 to nearly $172
billion in thethird quarter of 1987. Thus, until re-
cently, there was little evidericeofa.significant
turnaround in the nominal merchandise trade
deficit.
Starting in the first quarter of 1988, however, it
became apparent that the nominal trade deficit
was no longer increasing; by June there were six
months of data indicating that a sharp reduction
in the nominal trade deficit was taking place. AI-
though delayed, the improvement in the u.s.
external position has been dramatic. The mer-
chandise trade deficit fell from an annual rate of
$172 billion in the last quarter of 1987 to $120
billion in the second quarter of 1988, a 30 per-
centdropintwo quarters. The second quarter
improvement in the merchandise trade balance
also produced an improvement in the U.S. cur-
rent account balance, a broader measure that
includes trade in services and interest payments
on outstanding debt as well as merchandise
trade. The current account deficit was $133.3
billion (annual rate) in the second quarter of
1988, about $1 billion below its fourth quarter
1987 levels, and $14 billion below its value in
the first quarter of 1988.
News of the turnaround and the suhsequent dra-
matic improvements in merchandise trade in the
first half of 1988 may have caused markets to re-
vise their expectations of the size of the U.S.
external deficit in the future. This, in turn, would
have diminished concern that the dollar would
have to fall to maintain the u.s. external deficit at
a sustainable level. Consequently, the new infor-
mation on the dollar's impact may have caused
financial markets to revise upward their expecta-
tions of the future value of the dollar, producing
the appreciation observed from June to Septem-
ber 1988. In line with this explanation, the news
received in mid-October that the August trade
deficit had increased significantly may have
caused another reassessment of the trade deficit
and the long-run value of the dollar, producing a
significant downward adjustment in the valueof
the dollar.
The coincidence in the timing of exchange rate
movements and the announcement of news on
the u.s. trade balance supports the view that
changes in the market's assessment of the long-
run u.s. external position have recently influ-
enced the value of the dollar. If this relationship
persists, continued reductions in the external def-
icit will tend to strengthen the dollar, while
increases in the u.s. external deficit will tend to
weaken the dollar.
However, there is a great deal of disagreement on
the likely path of the u.s. external deficit in com-
ing months. Many argue that the deficit will rise
simply because of the U.S: status as a debtor na-tion. The interest payments on the large external
debts the u.s. has already incurred will add to
deficits in the external account.
Moreover, some observers argue that such "auto-
matic" increases in U.S. external deficits will be
reinforced by a secular tendency toward deficits
in merchandise trade. Specifically, in the ab-
sence of exchange rate changes, the u.s.
demand for imports tends to exceed that of its
major trading partners. Staff of the Federal Re-
serve Bank of San Francisco estimate that a one
percent increase in U.s. GNP produces a nearly
three percent increase in U.s. imports. In con-
trast, a one percent increase in the GNP of major
u.s. trading partners produces a 1.8 percent in-
crease in U.s. exports. Thus, in the absence of
exchange rate changes, u.s. trading partners
have to grow fifty percent faster than the u.s. to
balance u.s. trade. Since the long run (potential)
growth rates in the U.s. and its major industrial
country trading-partners are about the same, u.s.
imports will tend to be larger than u.s. exports
unless the dollar depreciates.
On the other hand, structural changes may be
taking placethat ultimately may reverse the secu-
lar tendency toward growing U.S. external
deficits. For example, some argue that the strong
dependence of the u.s. on imports is partly the
result of a decline in manufacturing capacity in
the u.s. tradable goods sector, caused by the
sharp appreciation of the dollar from 1980 to
1985. Conversely, the steepness of the dollar de-
preciation from 1985 to 1987 has probably
restored some u.s. manufacturing capacity in
tradable goods which may permanently reduce
u.s. dependence on imports and increase foreign
demand for u.s. goods without further changes
in the exchange rate. The demand for u.s. ex-
ports may also be increased by recent efforts to
lower trade barriers among u.s. trading partners.
If these offsetting forces are sufficiently strong to
reverse the secular tendency towardsgrowing
u.s. external deficits, there may be no further
downward pressure on the dollar from this chan-
nel. So far, however, there is no conclusive
evidence to this effect.
Conclusions
While investment spending in the present expan-
sion has certain remarkable characteristics, the
data examined suggest that the investment out-
look cannot fully explain the recent behavior of
the U.S. dollar. Ollfneofher halld,fhefimingof
changes in the exchange rate suggests that news
of improvements and deterioration in the mer-
chandise trade balance may have contributed to
the observed behavior of the dollar in 1988.
Although the course of the trade deficit and of
the dollar cannot be known with certainty, the
preceding analysis suggests that the Us. trade
deficit may increase, thus producing further
downward pressure on the dollar. These develop-
ments, however, could be muted to the extent
that significant changes in the u.s. trade struc-
ture have occurred that would permanently
reduce u.s. demand for imported goods and in-
crease foreign demand for U.S. exports.
Even in the absence of such changes in U.s.
trade structure, however, the long run impact of
the u.s. external deficit on the u.s. dollar is un-
clear. As pointed out in a recent Letter (October
7, 1988), there is a large world demand for u.s.
dollar assets that is growing apace with grOWing
financial integration and rising world wealth.
This demand may grow rapidly enough to sup-
port the U.S. dollar even if u.s. trade deficits
persist.
Ramon Moreno
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
Alaska Arizona California Hawaii Idaho
nevada Oregon Utah Washington
tI

The baffling dollar

http://www.frbsf.org/publications/economics/letter/1988/el88-49.pdf

The baffling dollar

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics