Myths of the Adjustment Process
Woody Brock’s February 2004 paper on the relationship between US interest rates and the big dollar is a neat debunking of much of the conventional wisdom on this subject:
• If foreigners become disenchanted with US assets, and demand higher yields, can they get them? [No, other things being equal.]
• Can foreigners as a whole “pull out” their money from the US, thus driving up US real rates? [No.]
• Can foreigners as a whole refuse to acquire more US assets in the future (in order to finance future US trade deficits) thus driving up US interest rates? [No.]
• As the dollar falls, will the US experience a dose of “imported inflation”, thus driving up nominal interest rates? [Yes, but less than ever before due to structural changes in the global economy.]
• Can Asian central banks stop acquiring US IOUs? [Yes.] And if so, would this development send US interest rates soaring as the consensus expects? [No, the value of the dollar would take the hit much more than US yields.]
• How much more will the dollar fall before a new and more stable equilibrium can be achieved - an equilibrium including a balanced US trade account? [Much more than it has - largely because the value of the dollar has not been the cause of today’s trade imbalances.]
Woody greatly overstates the likely exchange rate adjustment in my view (eg, AUD-USD above parity,* a 300% revaluation in the yuan), but his analysis of the irrelevance of this process to the determination of US interest rates is essentially correct.
* Afterall, Australia has its own record current account deficit, for which a similar adjustment process is required.
posted on 26 November 2005 by skirchner in Economics
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