The Fed's dollar question
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A key question for the Federal Reserve in the months ahead will be the U.S. dollar's future direction. That question will have a crucial bearing on the appropriate timing of the start of the Fed's interest rate hiking cycle. If it is thought that the dollar's recent strengthening is likely to be reversed, the Fed would be advised to start raising interest rates soon for fear of allowing domestic inflationary pressures to build up. By contrast, if it is thought that the dollar might very well add to its recent gains, the Fed would be advised to exercise patience before hiking rates for fear of setting back the economic recovery.

The relevance of this issue is underlined by the dollar's recent strength. Over the past six months, the dollar has appreciated by around 15 percent against a basket of currencies, making this the second steepest rise in so short a period since the dollar's floating began some 40 years ago. If sustained, such a rise could materially alter the U.S. economic outlook. Indeed, according to International Monetary Fund (IMF) estimates, if the past year's gain in the U.S. dollar is sustained, one could expect U.S. gross domestic product (GDP) growth to be around 1 percent lower than it would otherwise have been. Similarly, one could expect U.S. inflation to be around 1 percent less than otherwise would have been the case. Together with lower international oil prices, a strong dollar could very well contribute to a negative U.S. headline inflation rate before year-end.

In gauging the likely future direction of the U.S. dollar, it is well to start with trying to identify the causes of its recent strengthening. Among the more probable causes are the relative strength of the U.S. economy and the relative stance of U.S. monetary policy. At a time that the U.S. economic recovery has shown signs of gaining traction, those of Europe and Japan have shown signs of stuttering. Similarly, at a time that the Fed has chosen to end quantitative easing and to start raising interest rates, the European Central Bank (ECB) and the Bank of Japan (BOJ) are moving exactly in the opposite direction. In addition to committing themselves to maintaining interest rates at close to the zero bound for an indefinite period of time, both the ECB and the BOJ have now committed themselves to substantially expanding their balance sheets over the next two years.

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Further contributing to the dollar's recent strength has been the growing perception of the dollar as a safe haven from both the euro crisis and from Europe's exposure to the Russian-Ukrainian crisis. Following the election in January 2015 of a new Greek government openly hostile to budget austerity and economic reform, fears have been reignited about the possibility that Greece will soon be forced out of the euro. At the same time, the virtual collapse of the Ukrainian economy, coupled with the truculent stance of Russian President Vladimir Putin, have raised doubts about any early resolution to that geopolitical situation — which is more of a problem for Europe than it is for the United States.

If the causes of the dollar's recent strength are indeed those identified above, it is difficult to see why, far from weakening, the dollar might not strengthen even further in the months immediately ahead. In particular, there is little reason to think that the gap between the U.S. economic recovery and that of Europe and Japan will narrow anytime soon. Nor is there any reason to think that either the ECB or the BOJ will soon slow their pace of money printing, especially considering the deflation risk in both Europe and Japan.

Perhaps an even stronger reason for thinking that the dollar could strengthen further in the months ahead is the deepening Greek crisis. The souring of relations between Greece and Germany would seem to underline unbridgeable differences in view between the newly elected Greek government and Berlin on appropriate economic policies for Greece. With the Greek government already living from hand to mouth in its efforts to stave off default, it would seem to be only a matter of time before the country is forced to impose capital controls and to seek an official debt restructuring. As the specter of a Greek exit from the euro looms larger, one would think that the stream of money already flowing from Europe to the U.S. in search of a safe haven will only increase.

With the odds seemingly stacked in favor of further dollar strengthening, the Fed would be well-advised to take the dollar's strength into account when gauging when to raise interest rates. Failure to do so could lead to a costly policy mistake for the U.S. economic outlook.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.