THE rise of the US dollar in recent weeks has been significant. The dollar’s move has coincided with and, in some way, caused the decline of global commodity prices and as such, it takes place against the backdrop of a generally low inflation environment.
At the US Federal Reserve’s December meeting, the central bank was very clear about ignoring the impact of oil prices on the US inflation rate. Does the dollar’s move higher change US inflation and the Fed’s response? And could the dollar’s weakness provide a boost to the lacklustre economy of Europe and the recession-hit economy of Japan?
The answer to the questions is a pretty resounding “no”. The dollar’s strength is unlikely to delay US interest rate increases, nor is it likely to change the relative competitiveness of European or Japanese exports. The only prices that are likely to react to the dollar’s strength are commodity prices, because commodities are universally priced in dollars. Otherwise, very different conditions prevail.
Attending a conference in Mexico last month, I heard a former government minister extolling the virtues of the Mexican automobile manufacturers, pointing to the cars and SUVs that Mexico is selling to the US.
Then he noted, “but of course, the car that we sell in the US will already have crossed the US-Mexican border 17 times, on average”. This is one reason floating exchange rates have a limited impact. Global trade has become complex.
That “Mexican” car is stuffed full of components from the US and Canada, and whisked back and forth across international borders, before it is finally assembled in Mexico. It could more properly be called a North American car than a Mexican car. The value of the Mexican peso against the US dollar is a pretty small factor in the price of a Mexican car sold in the US.
It is the same elsewhere. Supply chains are long and complex. Finished products are simply agglomerations of cosmopolitan components from around the world. This lessens the importance of foreign exchange markets to international trade.
The other factor that reduces the importance of foreign exchange markets is pragmatism on the part of companies. Companies know that what goes up in the world of foreign exchange this year may well just come right back down again next year. Why risk customer loyalty and carefully nurtured market share by changing export prices every time the foreign exchange markets have convulsions?
Companies are prepared to accept fluctuations in their profit margins rather than jeopardise a market presence that may have taken decades to build. Companies set their prices according to local market conditions.
There is a simple way of demonstrating this. The US breaks down import prices and domestic producer prices into a large number of subcomponents. Economists can compare 128 sectors and subsectors of the economy.
If the dollar’s strength was going to have a meaningful impact on the import prices in these 128 sectors, then the correlation of import prices with the dollar’s movement should be higher than the correlation of import prices with US producer prices for the same products. If the producer prices are better correlated, then importers into the US are ignoring currency markets and focusing on local market conditions.
The result of such a comparison is overwhelming. About 16 of the 128 sectors could claim to have import prices that are influenced by the movement of the dollar. For all other sectors, the correlation to the dollar’s movement is low, and for nearly all other sectors, the correlation to domestic producer prices is greater than the correlation to the dollar.
In other words, importers into the US set prices according to local market conditions, and the movement of the dollar is background noise.
Therefore, the volume of exports from the rest of the world to the US is not likely to change. Why should it? The dollar prices of the products are not changing. Exporters to the US may make more profits when their dollars are converted back into local currencies, but that is a different story.
This means that the dollar’s strength is:
1. Unlikely to significantly increase importers’ market share in the US.
2. Unlikely to lead to a relative decline/competitive advantage for non-commodity import prices into the US, and thus limited US deflation pressures.
3. Unlikely to lead to a significant real gross domestic product boost from rising real exports in the eurozone or Japan, although the profits earned by exporters in the eurozone and Japan could independently generate growth if they are invested or paid out in higher wages.
Paul Donovan is senior global economist at UBS Investment Bank
This article first appeared in Forum, The Edge Malaysia Weekly, on December 29, 2014 - Jan 4, 2015.