The other side of the coin

- Editor


 Doubts about the US dollar can be traced to the broader uncertainties surrounding the US economy, but a weaker dollar is also a result of the way in which the US central bank is tackling the downturn.

Global sharemarkets are now discounting a recession in the US. In the meantime, the outlook for the world’s largest economy remains exceptionally uncertain. Some forecasters expect a mild and short recession (with modest negative growth in the first and second quarters of 2008), followed by a period of relatively low growth. Others predict a mild but longer recession. However, some experts expect a deep recession. The differences of opinion around the extent of the US economic downturn have rarely been as pronounced as now.

What the US Federal Reserve fears most is that these uncertainties will intensify the downward pressure on US economic growth. That is why it made clear as early as August 2007 that its overriding priority was to avert a deep recession. Turning words into deeds, it announced a series of aggressive interest rate cuts from September 2007 onwards.

A serious complication is that the economic slump coincides with weakness in the banking sector, so the US faces a combination of unfavourable factors: a weak economy and banking sector, and as a consequence inefficient credit and money markets. On top of that, inflation is moving upwards, owing to rising commodity and food prices and the dollar’s weakness.

Given this range of problems, the US central bank faces a formidable challenge. It is concentrating on countering the growth deceleration and utilising innovative measures to restore health in the financial sector. However, the decline in the value of the US dollar has boosted net exports and it helped bring the US current account deficit down to less than 5% of GDP by the fourth quarter of 2007, over 1.5% of GDP lower than its peak in 2006.

The uncertainties surrounding the US economy and the Fed’s interest rate cuts and liquidity measures are exerting downward pressure on the US dollar. This decline in US interest rates – while New Zealand interest rates remain on hold – has caused the interest rate differential to widen significantly. At the end of March, the difference between the New Zealand and US two-year swap rates was 5.65% compared to 3.00% at the same time last year.

Economic momentum has turned in New Zealand as well, although the situation is far more advanced in the US. The high inflation outlook prevents any prospect for an early easing, in spite of significant pressure on households and a sluggish economy. In the March quarter, New Zealand’s CPI rose by 0.7%, or 3.4% for the year.

The weak US dollar has created significant headwinds for exporters across the globe, but these are not insurmountable problems due to continued growth in other regions, particularly developing markets.
Strong growth in developing markets has been a dominant driver of commodity prices. This has helped insulate the impact of a weaker dollar on commodity exporters such as New Zealand, Australia and Canada.

A significant portion of the rise in commodity indexes is directly related to the fall in the US dollar. Many commodity prices are quoted in US dollars and therefore more dollars are required to pay for the same amount of a particular commodity. Furthermore, increased speculative activity in commodities can be traced back to a weaker dollar. Precious metals are often used as a hedge against a weak US dollar and higher inflation.