Originally published in THE BOSTON GLOBE

Tuesday, January 6, 1998

Shift in currency's rising value could rock US economy

Keep your eyes on the dollar

Martin and Kathleen Feldstein

"Even a dollar that just stabilizes will have important consequences. The rising dollar has postponed the need for the Fed to raise interest rates."

Whether 1998 will be another banner year for the US economy will depend very much on what happens to the dollar. The dollar's sharp rise since 1995 has been the key to our surprisingly successful recent economic performance. If this rise is reversed or even halted in 1998, it will become difficult to sustain the winning combination of strong growth, low inflation, and low unemployment.

The dollar's value is now 13 percent higher than it was in 1995. Wall Street analysts are divided about the dollar's likely behavior over the coming year. But market actions speak louder than words. Investors are now getting higher interest rates in New York than they can get in Tokyo or Frankfurt. This interest differential is consistent with a market expectation that the dollar will fall relative to both the yen and the European currencies that are linked to the mark. It will take some time to see who has got it right. But either way the dollar deserves a close watch in the months ahead.

The rise of the dollar since 1995 has helped keep a lid on inflation in several ways. A higher dollar immediately translates into lower import costs and this in turn puts pressure on domestic firms to keep their prices down to meet foreign competition. So even though imports account for only about 13 percent of gross domestic product, the competitive impact can affect the economy much more broadly.

Lower consumer price inflation has kept wage pressures down. Because consumer prices haven't been going up very much, employees have accepted modest wage hikes that have still meant a rising real standard of living. And it has been easier for firms to resist emerging pressure to raise wages by saying foreign competition has tied their hands. Firms won't raise wages if they can't raise prices.

For the monetary authorities in the Federal Reserve, low inflation has reduced the urgency to raise interest rates that would normally be felt at current levels of unemployment. The low interest rates have helped keep profits high by reducing the cost of corporate debt, and have directly contributed to the stock market boom. All these favorable effects would end or be reversed if the dollar were to stop rising.

There have been many factors behind the dollar's rise. Real short-term interest rates in the United States have risen as inflation has fallen with unchanged nominal interest rates. That has attracted foreign capital, as has the rising US stock market, thus bidding up the US dollar. Outside this country, the yen has weakened relative to the dollar because of declining Japanese interest rates and a very weak Japanese economy. And in Europe, concerns about the European Monetary Union and its possible destabilizing effect on exchange rates have sent investors seeking dollar assets.

Finally, since last summer irrational pessimism has caused plummeting exchange rates in Asia.

Almost any of these factors could change in 1998. While we would not rule out the possibility of the yen falling further because of risks in the Japanese financial system, it is more likely the yen, which is clearly undervalued based on the Japanese balance of trade, will begin to rise again. The government of Japan is under extreme pressure both domestically and from Japan's trading partners to pursue fiscal policies aimed at reviving economic growth and strengthening the yen.

With respect to Europe, there are offsetting tendencies again. By now, individual investors should have taken any steps they deem necessary to hedge against volatility in exchange rates that might accompany the start of EMU on Jan. 1,1999. But as the date approaches, it would not be surprising if psychological factors induced a further flight to the dollar. No one can predict exactly the net effect of euro nervousness.

Finally, the excess pessimism in Asia, particularly with respect to the Korean won, will reverse as investors recognize that these currencies have been oversold.

In our judgment, the net result of all these conflicting tendencies is more likely to be a falling dollar than a rising one over the next year. Although this will help US firms that export abroad to be more competitive, it will also put upward pressure on inflation domestically. This short-term pressure will have significant adverse consequences for wages, interest rates, and the stock market.

Even a dollar that does not fall but just stabilizes will have important consequences at home. The rising dollar has postponed the need for the Fed to raise interest rates to head off the inflation that usually flows from low unemployment and high-capacity utilization. The Fed has continued to stress that it is more likely to raise interest rates than to lower them. To judge the Fed's next move, watch what happens to the dollar.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics