The Hindu Business Line : Why a dollar collapse may not push up rates

The articles ‘US Fed: Between Scylla and Charybdis’ (Business Line, June 18) and ‘The collapsing dollar’ (Business Line, July 27) have made a combination of short- and long-term forecasts for the US economy, the dollar and US interest rates. The authors have documented the dollar’s depreciation against its major trading partners’ currencies in the past five years and forecast further significant dollar weakness over the medium-term as a natural consequence of the massive international imbalances the US suffers from.

They also take the short-term view that the current housing sector slump in the US will turn into a recession for the overall economy. The Federal Reserve may cut rates in such a situation, but the authors argue that such an easy policy cannot be sustained. An easing in policy, they contend, will push the dollar further down against its major trading partners and result in much higher levels of inflation in the US as imported goods become costlier.

In the event, while cutting rates could be a short-term palliative, the Fed would eventually be forced to raise rates substantially to counter the inflation caused by a free-falling dollar. Over the long-term, the view therefore is for stagflation in the US — where the economy buckles under the weight of higher interest rates but inflation is (high and) imported through the weaker dollar.

Dollar fall and link to inflation

This article takes the stance that while the dollar may fall further over the next quarter or even two, it may not lead to higher levels of inflation in the US. Thus, long-term interest rates in the US could continue to remain moderate, around 5/5.25 per cent (they are even lower now as this piece goes to press).

The higher dollar interest rates view rests on the sole point that a collapsing dollar will lead to a significant rise in US domestic price levels. But neither historical data nor the structural patterns of US trade (more importantly, trade invoicing), does not support that view.

A study of US trade invoicing patterns shows that a weaker dollar will not (and does not) automatically translate into higher inflation. In technical terms, the exchange rate pass-through to the domestic price level from a weak(er) dollar is quite weak.

In the past five years, while the dollar index has fallen substantially (evident from the steep fall in the US currency against almost all its major trading partners), the inflation in the US has broadly remained in the 2-3 per cent range. Long-term inflation expectations, indicated by the yields on inflation-protected securities, also are around 2.50 per cent. So, it is clear that the dollar’s significant depreciation has not caused any runaway inflation in the US and the overall expectation also is for inflation to stay around the 2.50 per cent levels in the medium/long-term. That is, the market does not expect the significantly weaker dollar to have an impact on domestic price levels even with considerable time lags.

Why the low pass-through

The low pass-through of the weaker dollar onto domestic prices is probably explained by the following two factors:

The high proportion of US trade, particularly imports, which gets invoiced in the dollar itself

Even where non-dollar invoicing takes place, the size and breadth of the US market compels overseas suppliers to absorb the effects of a weaker dollar into their own margins and leave dollar prices broadly unchanged for American consum ers. The objective is to retain share in a big, consumption driven market

Federal Reserve data show that as of 2003, as much as 93 per cent of all US imports was invoiced in the dollar itself. In such a situation, how does it matter to the US consumer what is the level of the foreign exchange value of the dollar? For the US consumer, dollar prices remain unaltered.

It is pertinent to note that not only is the dollar share of US import invoicing high, the dollar share of the export invoicing is quite high even for some of the non-Asian exporters into the US.

As the Table shows, around 25 per cent of all German exports is invoiced in the dollar and the US accounts for around 15 per cent of all German exports. Overall, for no other country, other than the US, is external trade so predominantly invoiced in its own currency.

Implications for Indian markets

For the Indian markets, both the short- and long-term implications of a weaker dollar, lower short-term US rates and stable long-term rates will be significant. India probably will have to brace itself for higher levels of capital flows in the short-term as the US economy slows and rates soften.