Thursday, January 29, 2009

Weaker U.S. Economy Makes U.S. Dollar Stronger

The reports released today on the U.S. economy all indicated that it remains extremely weak, with the number of people receiving unemployment benefits reaching an all time high in absolute numbers (though it is still well below the 1982 peak levels as a percentage of the work force) while both durable goods orders and new home sales dropped more than most analysts had expected.

Normally, when economic reports are weak the exchange rate of the currency of that country falls, yet as is reported here, currency traders reacted by pushing the U.S. dollar higher against the pound and the euro (though not against the yen).

This might seem strange, but it's not if you remember what I wrote last week about the link between stock markets and the yen. The U.S. has short term interest rates at zero and so they can't be lowered further in response to economic weakness. The ECB still has rates at 2% so they can be lowered by 2 more percentage points. And since a weaker U.S. economy increases the risk for a weaker European economy, a weaker U.S. economy will increase the risk of more ECB interest rate cuts, which will lower the interest rate differential.

One argument sometimes used for floating exchange rates is that the currencies of weak economies will weaken which will boost that economy by supporting exports. Yet as we see here, once interest rates reach zero, the effect will be the opposite, and a weaker economy will cause the currency to rise in value and so hurt exports.


Blogger novid said...


If I understand this correctly, that means that the pound should continue to fall relative to the dollar given the fact that the Bank of England still has their rates at 1.5% and are continuing to cut them.

The pound has had a precipitous fall from mid 2008. The same scenario should eventually play out for England when their rates are between 0-0.5% and obviously can't fall much further, right?

3:05 AM  
Blogger novid said...

Oh, one more thing. I forgot to mention this in my first comment.
Given this post as well as the Yen-Stock Market link, what is going to be the relationship of the Yen vs the Nikkei? Because based on what you are saying the Yen should continue to rally because everyday you hear how the Japanese economy is deteriorating due to global factors. (as well as the strong yen)

The jobless rate is increasing, households are cut spending, Toshiba is firing workers and Honda is cutting production. When will it go back to...lower production...decelerating earnings...falling stock market...weaker currency?

Am I missing something?

4:20 AM  
Blogger stefankarlsson said...

On your first point about the pound, you're right.

As for your second question as to when the normal relationship between economic strength and the strength of the currency will be restored, that will only happen once we see a more broad based global recovery.

6:52 AM  
Anonymous Anonymous said...

But will not the increasing money supply in USA lower the dollar?


8:25 AM  
Blogger stefankarlsson said...

Göran, in the long run it will lower the dollar's exchange rate by boosting dollar prices. But the short term effect is much smaller than usual because a higher money supply can't lower interest rates further.

4:09 PM  
Anonymous Michael Hayes said...

Dear Stefan,

U.S. economy remains extremely weak,this is evident with the number of people receiving unemployment benefits is all time high.When the economy is week the currency will also decrease but here it has been the opposite. Unless the currency depreciates the revival of the economy would be slow.

Michael Hayes

8:00 AM  

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