-->The Northern Trust Company
Economic Research Department
Positive Economic Commentary

“The economics of what is, rather than what you might like it to be.”

50 South LaSalle Street, Chicago, Illinois 60675
Web Page -- http://www.northerntrust.com (See Economic Research)
Paul Kasriel (312)-444-4145 Fax (312)-444-4132
Friday, January 23, 2004

Future Inflation Is Chief U.S. Export

The U.S. dollar, if left to its own devices, would sink versus the world’s major
currencies. In fact, since its recent peak on January 28, 2002, the value of the
dollar vs. a trade-weighted basket of other major currencies has declined by about
25%. Why is the dollar depreciating? My view is that global investors are starting to
worry about how the U.S., which has a net financial asset deficit with the rest of the
world of about $4 trillion and is adding to that deficit at an annual rate of almost
$550 billion, will pay the interest and dividends due them - forget about the
principal - in coming years. Global investors may be coming to the opinion that the
U.S. will attempt to pay them back in freshly-printed, figuratively speaking, dollars.
If that were the case, those dollars would have less command over real goods and
services. So, global investors - at least private-sector profit-maximizing global
investors - are slowing down their demand for U.S. dollar-denominated assets,
hence, the decline in the dollar vs. other currencies.
The U.S. dollar prices of most goods, services, and assets are rising at a faster rate
these days. About the only exception to this is in the “official” measures of
consumer prices. It appears that foreign-economy policymakers, for reasons that
baffle me, are desirous of importing some of this U.S. inflation. When the yen, the
euro, and the loonie rise relative to the dollar, the residents, in the aggregate, of
Japan, the euro-zone, and Canada enjoy an increase in their standards of living
because they now have to give up fewer of the goods and services that they
produced for a given amount of U.S. goods and services. Sounds good to me, but
evidently, not to foreign-economy policymakers.
For whatever reason, foreign-economy policymakers want to prevent their
currencies from rising against the dollar, or, at least, to slow the rate of increase.
So, they either are, or are threatening to, increase the amount of yen, euros, or
loonies that their central banks “print” to counter the excess supply of dollars
floating - or more precisely - sinking around. This past week, the Bank of Japan
announced that it was easing its monetary policy by raising the amount of yen
excess reserves it intends to force on the Japanese banking system. Then, the Bank
of Canada cut the interest rate at which it stands prepared to lend loonies to the
Canadian banking system. All else the same, this will increase the supply of loonies.
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And now, euro-zone policymakers are hinting that the ECB might be prevailed upon
to cut the interest rate at which it lends euros to the banks. These currency-induced
moves by foreign central banks will have the effect of eventually making the
inflation rates abroad higher than they otherwise would be.
Something similar to this occurred in the late 1960s and early 1970s. There was an
excess supply of dollars being created, which was causing the U.S. inflation rate to
rise. Foreign central banks, in order to keep their respective exchange rates at a
fixed relationship to the dollar, which was the “rule” back then, had to increase the
supplies of their currencies. But as foreign inflation rates started to rise, foreign
central bankers began to balk at printing more of their currencies to maintain the
peg with the dollar. Some central bankers, most notably the president of the French
central bank, had the audacity to demand gold for the excess supply of greenbacks
it was being forced to accumulate. Well, the U.S. government simply did not have
enough gold to meet the demands of all those central bankers who wanted some in
exchange for dollars. As a result, the U.S. reneged on the promise to pay out gold
for dollars to other central banks, and the dollar sank. U.S. inflation then
skyrocketed, as did U.S. interest rates. It took a courageous Fed chairman, Paul
Volcker, about eight years to tame both U.S. inflation and inflation expectations.
How long will it be until U.S. exported inflation becomes an irritant to foreign
central banks? China, which was experiencing a mild deflation at the start of 2003
ended the year with a mild inflation. Japan’s deflation appears to be nearing an
end. My bet is that in 2005, foreign central bankers will have had their fill of
countering the dollar’s natural inclination. When that happens, the dollar will likely
go into an uncontrolled tailspin and the Fed will have jack up interest rates. It will
be interesting to see how the most highly-leveraged U.S. economy in at least 55
years (as far back as my data go) reacts to all of this. In the interim, commodity
prices in dollar terms, which already have been on a tear, will likely continue to
rise. The combination of falling dollar and global reflation is a recipe for higher
commodity prices.
Do you think Paul Volcker could be persuaded to come out of retirement to save us
again?
Paul L. Kasriel, Director of Economic Research