The foreign exchange market sees an average daily turnover of something on the magnitude of $6.6 trillion a day. In a week, the turnover is sufficient to more than cover world trade for a year. It is the largest of the capital markets. Trends in the currency market can last for years.
A little more than a year ago, we concluded that the dollar’s third significant rally since the end of Bretton Woods was over and that a cyclical dollar decline was at hand. Yet the dollar’s price is only known relative to another currency, and there are more than 100, or a basket of currencies. What exactly does it mean that the dollar’s “third significant rally” was over?
Here is a chart of the dollar that is the best measure of its economic impact. It a broad trade-weighted measure the is adjusted for inflation. The real broad trade-weighted dollar index is the way the Federal Reserve thinks about the dollar as well. The chart here from Bloomberg goes back to the 1970s. Nixon broke the last link between gold and the dollar on August 15, 1971. There is an attempt to put Bretton Woods back together, but it fails. The first big dollar rally we associate with Reagan, though in fairness, it began before he took office. Nevertheless, the Reagan dollar rally was a function of the policy mix. There was a tight monetary policy from the Volcker Fed as double-digit inflation is squashed with punishing interest rates despite high unemployment. Meanwhile, Reagan pushed on the fiscal accelerator. Taxes were cut, and defense and social spending increased. Such a policy mix, loose fiscal and tight monetary policy, appears to be the most favorable for a currency.
The dollar enjoyed its first post-Bretton Woods rally, but it proved too much. The marked appreciation of the greenback led to a widening trade deficit and protectionism at home. The strength of the dollar was kindling inflation pressures in Europe and Japan. Officials from the G5 met at the Plaza Hotel in New York and agreed to drive the dollar lower through joint intervention. The dollar went through about a ten-year bear market.
Starting in the spring of 1995, the dollar’s second significant dollar rally began. The Clinton dollar rally was a function of the new technology rally, the age of the PC. Americans kept their savings at home, and foreign investors could not get enough of the new economy stocks. Another change took place, which was also important. Robert Rubin replaced Lloyd Bentsen at the head of the Treasury Department. He needed to distinguish himself from his predecessor and announced a “strong dollar policy.” This shift was important even though it was disputed nearly from the start, and the policy lasted for nearly two decades through Democratic and Republican administrations.
The “strong dollar policy” was never about the exchange rate per se. It was a pledge to…
Read More: The dollar’s evolving outlook