Dollar’s weakness is Bernanke’s strength

Dollar’s weakness is Bernanke’s strength
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First Published: Mon, Sep 24 2007. 12 59 AM IST
Updated: Mon, Sep 24 2007. 12 59 AM IST
The US Federal Reserve’s half percent cut in the overnight interest rate was a bold shot to restore confidence in the US economy. Will it work?
The challenge is great. Rising house prices have helped to propel US growth since 2001. In 2006 alone, they added $1.1 trillion (Rs43.9 trillion) to the assets of American households: a colossal rise, equivalent to 8% of the gross domestic product (GDP). That paper wealth fed into real spending, through both refinancing and enhanced confidence.
But now that house prices are falling in many parts of the country, the opposite effect will be felt. Consumers, less wealthy than they were, are likely to save more and spend less. That in turn threatens a fall in growth, further depressing house prices. This is the downward spiral that the Fed is seeking to avert.
It won’t be easy. No immediate improvement is possible in housing. The inventory of unsold homes rose to 4.6 million in July, the highest level since 1991. That huge inventory implies there will be further price falls—and further distress in credit markets.
But if lower short-term interest rates help ease the credit crunch, the Fed should be able to coax mortgage rates down, provided inflation expectations don’t climb. Future expected inflation influences long-term bond yields, the base for determining most US mortgage rates. The interest rate cut is risky because it might increase inflation indirectly, by pushing the dollar down and import costs up.
Yet it is the very weakness of the dollar, combined with the strength of the world economy, that gives Bernanke’s shot a chance of working. The broad trade weighted index of the dollar has fallen by 24% in the past five years. That favours US companies, encouraging exports and making it harder for foreign competitors in the US. In the second quarter of this year US exports rose by 7.6% while imports fell by 3.2%: a combination of export penetration and import substitution that generated 1.4 percentage points of GDP growth.
The US, with its huge trade deficit, has long needed a spell of export-led growth. It’s enjoying it now. And it is that export-led dynamism which gives the Fed’s shot a sporting chance of working.
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First Published: Mon, Sep 24 2007. 12 59 AM IST