The myth of a strong dollar policy.

A strong dollar policy is the yeti of economies. Despite occasional sightings, most recently by the National Association of Manufacturers, the American Farm Bureau, and the AFL-CIO, scientific evidence indicates that no such species exists. (1) The U.S. Treasury, which sometimes hints that it harbors the beast, simply lacks flexible policy instruments with which to manage dollar exchange rates. To be sure, U.S. tax policies help create an investment climate that attracts (or deters) international financial flows, and those flows affect dollar exchange rates. Some observers, for example, maintain that tax reforms in 1981 encouraged financial inflows and bolstered the dollar's exchange value and that tax law changes in 1986 had just the opposite effect. The Treasury, however, does not--and should not--manipulate tax policies to manage the dollar. Treasury officials also occasionally comment on exchange rates and create temporary blips in the market, but official pronouncements cannot sustain an exchange value.

While the Federal Reserve has the policy instruments with which to pursue an exchange rate objective, doing so has one of two implications: Either the Fed achieves its exchange rate goal at the expense of its inflation objective, or the exchange rate target is irrelevant because maintaining the inflation objective also promotes the exchange rate goal. The Fed came to this realization gradually over the past 30 years, after repeated and largely unsuccessful attempts to influence exchange rates. Since the early 1990s, the Fed has generally eschewed exchange rate policy in favor of an inflation objective, leaving the highly efficient foreign exchange market to determine rates.

In this article, we describe the instruments available to the Treasury and to the Federal Reserve System for affecting exchange rates. We explain why Treasury interventions, which have no effect on the Federal Reserve's target for the federal funds rate, have very little, if any, effect on exchange rates. Then we discuss the dilemma that the Fed faces when it attempts to achieve two policy goals--an exchange rate objective and an inflation target--with monetary policy alone. We conclude with a note on the efficient nature of exchange markets. We begin, however, by explaining why the traditional metric for judging the dollar overvalued, or too strong, offers a poor description of its equilibrium.

What Does a Strong Dollar Policy Look Like?

Strong dollar policy sightings usually accompany an appreciation of the dollar, particularly when that appreciation takes the dollar substantially above its purchasing power parity (PPP) level. Critics then complain that the dollar is overvalued, implying that its current value does not represent equilibrium, and warn that the situation is detrimental to U.S. economic interests and that the Treasury should alter its strong dollar policy to correct the problem.

"Overvalued" can be a subjective and vague term, but economists usually adopt relative PPP as the metric. A currency is "overvalued" if its current exchange rate exceeds its relative PPP value. The relative PPP theory holds that over time exchange rates will move in such a manner as to exactly offset international inflation differentials among countries. If the annual rate of inflation in the United States is 4 percent and the annual average rate of inflation abroad is 2 percent, then the relative PPP theory predicts that the dollar will depreciate 2 percent per year on average against the currencies of our trading partners. Similarly, if the rate of inflation in the United States is lower than that experienced abroad, the dollar should appreciate by exactly the difference between the domestic and foreign inflation rates.

Real exchange rates, such as the Fed's real broad dollar index (Figure 1) provide the easiest way to gauge PPP. The Fed constructs the index so that it equals 100 when PPP holds between the dollar and a weighted average of 36 of our most important trading partners. The real broad exchange rate index began to rise above 100 in 1998, indicating that the dollar was exceeding it relative PPP value.

[FIGURE 1 OMITTED]

When the dollar exceeds its relative PPP value, U.S. goods and services are priced out of world markets. The appreciation of the dollar after 1998 seriously eroded the competitive position of U.S. manufacturers and farmers. Conceptually, this development creates arbitrage opportunities, shifts worldwide demand patterns, and alters prices and exchange rates in such a way as to restore relative PPP. Unfortunately, the reversion back, as Figure 1 suggests, can take many years. Empirical estimates suggest that the average half-life of the process is anywhere between two and five years. (2)

Although the dollar …