Keep Your Eye on the Falling Dollar : It Could Push Interest Rates Up, Lead to Stubborn Recession

The unusually sharp decline in the international value of the dollar, which began in late December, is an important reminder of just how rapidly the dollar can fall.

The possibility of a major drop of the dollar is one of the serious risks that our economy faces in 1987. Although this year is likely to be one of continued economic expansion, a sharp enough fall could trigger an interest-rate jump that would push the economy into recession.

In principle, the dollar’s decline--a necessary step for restoring U.S. international competitiveness--can be achieved without precipitating a recession or raising interest rates. The dollar has been declining for nearly two years from its overvalued level at the start of 1985, and the economy has continued to expand throughout this period. We’re convinced that the dollar must drop even more substantially in order to bring the United States back into balance with our trading partners. Moreover, a further decline in interest rates is more likely than not.

But a sharp dollar drop might shock the economy by causing a spurt of inflation and a jump in real inflation-adjusted interest rates. An increase in inflation would result directly from the higher cost of imports caused by the fall of the dollar. A jump in interest rates would reflect the smaller capital inflow from abroad as foreigners and Americans no longer wish to invest as much in dollar securities or lend as much to American borrowers. With less foreign capital to finance both public and private borrowing, interest rates tend to rise and thereby discourage borrowing and investment.

During the last two years, the decline in the dollar did not precipitate such a rise in interest rates. That’s because the federal government’s borrowing to finance the budget deficit has declined from more than 5% of gross national product in 1984 to less than 4% now. The government’s borrowing therefore has consumed a smaller share of U.S. savings, allowing our interest rates to decline in parallel to the dollar’s fall. Similarly, inflation has not increased because the fall in the price of oil has more than offset the higher import prices that resulted from the dollar’s decline.

The risk now is that there won’t be a continued decline in government borrowing to offset the reduced capital inflow from abroad. Congress and the Administration appear to be heading for a budget impasse that leaves little hope of progress in federal deficit reduction. A sharp dollar drop, with its implication of a reduced capital inflow, would therefore cause interest rates to rise.

The countervailing effects on economic activity of a decline in the dollar and a rise in interest rates makes the net impact on the economy uncertain and impossible to offset. The lower dollar would encourage exports and reduce imports, but the higher interest rates would depress activity in construction and those industries that manufacture consumer durables and business equipment. If the expansion of net exports responds to the lower dollar more slowly than the domestic interest-sensitive industries respond to the rise in interest rates, there is a strong possibility that a large decline in the dollar could push the economy into recession.

If a sharp dollar decline does trigger an economic downturn, the traditional counter-cyclical monetary and fiscal policies would not be available to turn the economy around. Any attempt by the Fed to offset rising U.S. interest rates with easier money would probably be self-defeating. Such a policy would cause investors around the world to anticipate a rise in U.S. inflation. Since inflation reduces the purchasing power of the dollar, the increase in expected inflation would immediately force the dollar down further and cause interest rates to rise.

With the federal budget deficit starting at nearly $200 billion and being swelled by the economic downturn, there would be no room to try a counter-cyclical tax cut or an increase in government spending. Indeed, an agreement to reduce the deficit in future years would be far more beneficial than an increased deficit since it would cause a decline in real interest rates.

But if the deficit stalemate continues while a steep fall of the dollar causes interest rates to rise, the best hope for sustaining the expansion would be a revenue-neutral fiscal stimulus aimed at increasing interest-sensitive spending. The most reliable such stimulus would be a temporary return of the investment tax credit, financed by excise taxes on alcohol or gasoline. The experience with this credit over the last 25 years shows that even such a revenue-neutral package could be an effective offset to a rise in real interest rates. While a renewed investment tax credit would also keep interest rates higher than they might otherwise be, the net effect would be a stronger pace of expansion and a healthier economy.

There is, however, no way to escape the uncertainty and the risks that accompany the current situation of an overvalued currency and an obdurate budget deficit.