With everyone and their pet rabbit convinced the US Dollar strength continues, we thought some longer-term context on the 'strength' of the dollar was useful...
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Here is Goldman Sachs' Noah Weisberger take on Lessons From History:
While the real-trade-weighted USD is now at its strongest level since 2009, having already appreciated about 7% since July, the move is still quite modest when put in the historic context of real USD moves in the post-Bretton Woods era, and, in particular, the two periods of significant dollar appreciation from October 1978 to March 1985 and from July 1995 to February 2002. We look into the drivers of these past dollar-strengthening episodes, and what these lessons from history might mean for today.
The basics: Why does the dollar strengthen?
The causes and consequences of a stronger USD can be hard to disentangle. Different economic impulses can produce the same end “result” in terms of currency moves, but may have different implications more broadly. In particular, contractionary monetary policy, expansionary fiscal policy, or a reduction in country-specific risk can all plausibly leave the similar footprint of a stronger local currency (and declining net exports). Focusing on these root causes helps to point out critical similarities and differences between historical episodes and the current context.
1978-1985: US policy exceptionalism
From 1978 to 1985 the USD appreciated by 53% in real, trade-weighted terms, driven in large part by coincident shifts in US economic policy. In a departure from the prevailing policy stance, US monetary policy became far more contractionary, as the Volcker Fed sought to aggressively combat inflation and deeply ingrained inflationary expectations. Both long- and short-term interest rates climbed sharply throughout, and inflation and inflation expectations declined dramatically. At the same time, US fiscal policy became expansionary, with US deficits turning sharply more negative, and debt to GDP surging – even on a cyclically adjusted, “structural” basis. Each of these shifts alone would have pointed to a stronger currency; together, they amplified the impacts.
The 1978-1985 episode saw USD strength coinciding with a decline in net exports. From an accounting perspective, a declining current account is tied to a shortfall of US saving relative to US investment. In the 1980s, the widening current account was driven by declines in both savings and investment, with the savings shortfall even more dramatic. This is a very different “pattern” of current account widening relative to the 1990s.
1995-2002: US growth exceptionalism
The 1990s episode of dollar strength, with the real dollar appreciating by 34%, likely had more to do with a shift in some combination of improved perception of US risks as well as persistent and, perhaps exceptional and unexpected, demand strength. Indeed, economic growth was elevated, consumer spending was strong, savings rates declined and incomes grew. Critically, productivity growth was accelerating, keeping inflation dormant and helping to sustain the longest US expansion on record. The US fiscal balance improved, deficits got smaller, and interest rates fell.
Despite a very different backdrop relative to the 1980s, the net result was similar: a stronger USD, a decline in net exports and wider trade deficits. But unlike the 1980s episode, the widening current account deficit of the 1990s was driven by accelerating investment with savings unable to keep pace. Thus, the virtuous cycle of lower interest rates, lower debt payments, capital deepening, and productivity growth helped to make the 1990s dollar appreciation – at 120 months from trough to peak – the longest on record (so far).
But toward the end of this episode, USD strength may have had more to do with US risks looking far better than other alternatives, with external currency crises enhancing the relative “virtue” of the US. That the Asian crisis barely touched the US economy itself only helped to reinforce the dollar strengthening trend that had already been in train for some time.
Today: more exceptional in growth than in policy
While neither historical analogy is exactly right – and to be clear, our forecasts do not envisage a move as large or as long as the past episodes – there are elements of both episodes that currently seem to be in play. From a policy perspective, on the fiscal side of the ledger, our US forecast does not envisage much of an incremental positive impulse from government spending, with the budget deficit steadily improving. But, in 2014 some of the growth boost did come from a relaxation of fiscal tightening, which can be thought of as a positive fiscal policy impulse.
Similarly, on the monetary policy side, we do expect the Fed to start raising rates in 3Q2015. Although rate increases are expected to be modest, well telegraphed, and implemented against the backdrop of moderate inflation (at worst), the US monetary impulse seems magnified by the fact that the rest of the world, certainly in Europe and Japan, is leaning in the other direction. So here too, elements of contractionary monetary policy may be helping to support the USD, as in the 1980s.
But comparisons to the 1990s seem more apt in terms of the type and source of the relative exceptionalism. First, US growth is far more robust than elsewhere in the world, and yields, already higher, are expected to rise, both of which support and could be reflecting improving US risk sentiment, which would match the 1990 experience. Also, while not the same as a productivity shock, falling oil prices and the growing importance of the domestic oil production sector can deliver some similar economy-wide dynamics, which would also be more in line with the 1990 USD strengthening episode. Indeed, recent current account weakness seems to be spurred by a declining saving rate – as house prices and equity prices boost wealth – while investment spending is on the rise, again, in a pattern reminiscent of the 1990s.
This comparison has important implications for US policy in response to dollar appreciation. On the weaker economic backdrop of the 1980s, the competitiveness of US industry and agriculture suffered from a stronger currency. Protectionist sentiment escalated until the 1985 Plaza Accord between the US and its trading partners devalued the dollar. The 1990s, on the other hand, saw a relative absence of protectionism, as improving productivity and growing trade made dollar strength less of a target for policymakers.
On net, the greater similarities with the relative “growth exceptionalism” of the 1990s are perhaps comforting, with dollar strength more an outcome of positive developments – that are likely to continue – than the negative, defensive drivers that forced the “policy exceptionalism” of the 1980s.
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Perhaps this "growth exceptionalism" should look at today's PMIs and Philly Fed data and reconsider...
