Do you remember Nigel Lawson? The UK’s chancellor under Mrs T’s boom then bust period, had one big weapon for fighting inflation. He believed the secret to low inflation was a stable currency, and even before the UK joined the ERM, adopted a policy of shadowing the DeutschMark . He managed this by using the rate of interest, the theory being: the higher rates, the stronger the pound. A theory that was dashed a little when sterling was ejected form the ERM on that torrid and famous day in 1992.
But, if Mr Lawson was half right, a falling currency should lead to inflation. So a relatively high rate of interest will not only fight inflation directly, it should also strengthen the local currency, effectively giving rate setters a double sided blade for tackling rising prices.
This takes us on to the US. They have been predicting a fall in the dollar for some time, and over recent weeks, the greenback has been obliging. This morning, when we took our daily reading there were 1.9522 dollars to the pound. That’s a twenty-month record, but just a whisker short of a 16 year high. In December 2004 the dollar stood at $1.9548, a few tenths of a cent higher than the price we described above, and that 2004 peak was the highest level since the pound was ejected from the ERM.
With the US suffering from such a massive balance of payments deficit, it’s no surprise the dollar is falling, but what effect will this have on the US?
There are advantages and disadvantages of a falling currency, but from Uncle Sam’s point of view, the advantages are great, the disadvantages quite small. The big plus side is obvious: a lower dollar will boost US exporters. As for the main negative, that a falling dollar will lead to higher inflation and higher rates, well maybe it’s not so bad. The US is a relatively closed economy, in fact imports of goods and services account for only 15% of US GDP, compared to 30% in the UK. So a fall in the currency is unlikely to lead to a big jump in inflation, so rates should not have to rise by much at all.
As for the rest of the world? A lower dollar means it’s tougher for companies to export their wares into the US. In another era this would have had a catastrophic effect, but we are not so reliant on the US for trade these days. As that august economic consultancy, Capital Economics said: ” if the dollar is falling across the board, as we expect, the burden would be more evenly spread. For example, the impact on the euro-zone economy of a rise in the euro to 1.40 against the dollar will be much less if the dollar is also falling against other European and Asian currencies, than if that move purely reflected euro strength. On this occasion we expect China in particular to respond to broad-based weakness in the dollar by allowing a more rapid appreciation in the renminbi against the US currency. This will spread the burden further.”
.Besides, we have seen worse. Once again, we are letting Capital Economics have their say: “The dollar had already weakened by more than 25% between 2002 and 2004. And there was an even bigger fall - around 40% - after the Plaza Accord in 1985. During these periods, the global economy and financial markets performed reasonably well. ”
So you see, while many think a fall in the dollar is inevitable, that’s no reason to predict doom.
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