Nevertheless, the risk of a sharp dollar decline is worthy of consideration because:
* The dollar is overvalued in terms of trade competitiveness.
* The U.S. current account deficit is significant and is likely to grow over the next 12 to 18 months.
* A dollar decline would worsen the U.S. economy.
* There is no easy, effective remedy that would necessarily halt such a slide.
A strong dollar has resulted in a loss of trade competitiveness and dramatic deterioration of the U.S. trade and current account balances. These imbalances are not a problem as long as foreign investors want to increase their holdings of dollar-denominated assets at an increasingly rapid rate. But dollar weakness would generate consequences for the U.S. economy that would reduce the attractiveness of dollar assets further.
The initial impulse created by a falling dollar is higher inflation and slower growth. A weaker dollar leads to higher import prices and there is more room for domestic producers to raise prices as competitive pressures from abroad moderate.
Eventually, a declining dollar would stimulate U.S. economic activity by improving U.S. competitiveness, but it would probably take a year or more for a dollar decline to have a significant positive influence on economic growth.
A sharp dollar decline would prove awkward for U.S. policymakers. For Federal Reserve officials, it would worsen the trade-off between growth and inflation. If the dollar were falling sharply, this would increase the motivation to raise interest rates.
However, whether this would save the dollar is unclear. If the Fed, in an effort to support the dollar, increases interest rates, it may cause investors to become more pessimistic about the U.S. growth outlook. Most likely, the Fed would be slow to react because the initial stages of dollar weakness may simply be a reversal of earlier dollar strength.
The initial effect of a significant dollar depreciation or gross domestic product growth would probably be negative, because the real income of U.S. consumers would decline more than the rise in real income of U.S. exporters. Also, the impact of income on spending is probably larger for consumers than for businesses.
The long-run impact would be significantly positive as the change in relative prices induced foreigners to buy more U.S. exports and U.S. consumers to buy fewer imported goods.
Since 1970, stock market performance is generally positive when the dollar is declining. However, today's stock market could potentially be more negatively affected by a weak dollar than in the past. To the extent that a weak dollar creates an outflow of foreign capital, foreign demand for U.S. stocks would diminish. Foreign investors directly hold about 11 percent of the U.S. stock market, compared to about 6 percent in 1991.
Some industries benefit when foreign demand rises due to a weaker dollar. Soft drinks and semi-conductors, for instance, have a long-standing dependence on exports for healthy profits, so a weaker dollar tends to lead to improved global sales. However, to the extent that raw materials are purchased locally, a weaker dollar can have a negative impact on the cost structures of companies with overseas operations. Therefore, companies with significant foreign sales do not necessarily benefit in a climate where the dollar is weakening. Anthony S. Vargo is director of investment management for Legend Financial Advisors Inc. Reach him at (412) 635-9210.
Consumers and businesses project that prices will be lower in the future, so they delay their purchases, making the economic climate worse and driving prices and wages down further. Households with decreasing wages and companies experiencing decreasing revenue and extensive debt are still forced to meet their fixed monthly expenses.
Often, bankruptcies result or spending is cut to meet obligations. This is what happened in the early 1930s, triggering the Great Depression.
For the past 12 years, Japan has faced and continues to experience deflationary pressures as prices fall. This type of deflation is characterized as "bad deflation."
On the other hand, price declines may occur when companies find ways to produce goods and services more cheaply. These productivity gains are passed on to consumers in the form of lower prices and on to workers as higher wages, as well as on to shareholders as higher profits. This mild deflation is considered "good deflation."
Some see a strong possibility of mild deflation developing in 2003, as the lackluster U.S. economy continues to face concerns over excess capacity, weak employment growth, high levels of consumer debt and deflation exported from the Pacific Rim countries. This combination of factors could lead to mild deflation in 2003.
Historically, however, mild deflation alone has not been a negative to either the stock or bond markets.
All deflation is perceived to be bad because it has been associated with past economic downturns. However, not all deflation occurs during economic weakness. Deflation may also occur during the early stages of an economic rebound, particularly when business confidence and inventory rebuilding advance ahead of consumer demand.
As the economy reverts back to equilibrium, deflationary pressures typically ease. Stock market performance tends to be better during nonrecession years when mild deflation exists.
Long-term interest rates are typically higher during high deflation periods due to weak economic conditions. Periods of deflation, whether mild or significant, usually tend to cause short-term interest rates to rise to levels somewhat higher than long-term average interest rates. Anthony S. Vargo is director of investment management for Legend Financial Advisors, Inc. Reach him at (412) 635-9210 or firstname.lastname@example.org.