Federal Reserve should let exchange rates float and pursue better inflation management to deal with the dollar’s volatility.
By Patrick Horan
For the past two years, the U.S. dollar has been especially strong relative to other major currencies. The greenback’s strong appreciation has prompted Wall Street Journal columnist Joseph Sternberg to contend that the Federal Reserve should take a larger role in managing our nation’s currency.
Sternberg, who is concerned that exchange rate volatility can be destabilizing for global markets, argues that the Fed should publish forecasts of the dollar’s exchange rate just as it publishes quarterly forecasts of inflation, unemployment and real GDP growth. In his view, an even better development would be for the Fed to coordinate with other central banks to moderate exchange rate swings by minimizing the interest rate differential between countries.
Sternberg is not the only one concerned about exchange rates. In April, advisers to former President (and current candidate) Trump reportedly raised the idea of devaluing the dollar by threatening other countries with tariffs to boost American exports.
Although trying to fix the dollar exchange rate vis-à-vis other currencies might sound desirable, such a strategy would come with serious drawbacks, such as the difficulty of maintaining sufficient currency reserves and potential limitations on the free movement of capital. A better strategy would be for the Fed and other central banks to focus on domestic monetary conditions in their respective countries. Sounder domestic monetary policy across countries would allow currencies to float against each other, but it would dampen extreme volatility.
Some Exchange Rate Basics
If a country’s government wants to change its exchange rate, its central bank or treasury will typically buy or sell quantities of its own currency using the relevant foreign currency in exchange markets until it achieves the desired exchange rate. When setting monetary policy, a country needs to decide whether it wants a fixed exchange rate, where it aims to keep its currency stable with another currency, or a floating exchange rate, where private actors determine the exchange rate through their decisions to buy and sell currencies.
Fixed exchange rates have some attractive features, at least on paper. A predictable exchange rate makes trade simpler. Suppose an American company bought a machine from a European seller for €1,000,000, and the dollar-to-euro exchange rate was 1 to 1. The American company would need $1,000,000, plus a fee to convert the currency, in order to buy the machine. However, suppose the euro strengthens, so $1.10 is needed to buy €1. Now, the American company needs $1,100,000 plus the conversion fee to buy the machine.
With a floating exchange rate, importers need to consider changing exchange rates when buying from abroad, which makes it more difficult to calculate a transaction’s true costs. By contrast, if the exchange rate is pegged, importers can more easily assess costs. A fixed exchange rate can also encourage investment from one country to another because the exchange rate is predictable.
Although fixed exchange rates can encourage trade and investment, they can be very difficult to maintain. First, they require a country to maintain adequate reserves of a foreign currency to make any necessary interventions in exchange markets. This may not be a problem for disciplined countries, but it can be disastrous for an undisciplined country.
For example, in the 1990s, Argentina tried to maintain a fixed exchange rate with the U.S. dollar. While this plan initially worked, the Argentine central bank did not keep sufficient reserves of dollars. Rather, it kept some reserves in the form of Argentine government bonds. The Argentine peso then sharply appreciated alongside the dollar in the late 1990s.
Frequently, when a currency appreciates, consumers benefit because imports become cheaper, but exporters suffer because it becomes more expensive to produce goods. The strong peso coupled with an already burdensome regulatory environment caused Argentina’s economy to spiral into depression, and Argentina was forced to abandon the fixed exchange rate.
Second, a fixed exchange rate forces a country to give up either monetary autonomy or free movement of capital; a country can have two of these features simultaneously but not all three. This concept is called the “Impossible Trinity” in macroeconomics. For example, suppose that the dollar-euro exchange rate is 1 to 1. Capital (financial assets) will move from the country with lower interest rates to the country with higher interest rates.
To see why, let’s assume capital flows into the U.S., which has higher interest rates. The inflow of capital would increase demand for dollars because dollars are needed to buy the higher-interest-earning assets. This would cause the dollar to appreciate.
To preserve the fixed exchange rate under these circumstances, U.S. policymakers would have two options. The Fed could pursue a more expansionary monetary policy, so that the interest rate differential between the U.S. and the Eurozone would disappear. This means, however, that inflation could rise beyond what the Fed desires. The other option would be to impose capital controls, taxes or outright limits on capital flows, to reduce the inflow of capital into the country. Generally, policymakers do not like this option because capital controls are likely to discourage investment in their respective currencies.
For these reasons, most countries (and practically all large, developed countries) have chosen to forgo fixed exchange rates and instead have floating exchange rates, which allows them to retain monetary autonomy and free movement of capital. Floating exchange rates are market-driven, so they reflect what market participants think about the underlying fundamentals of a country’s currency. Moreover, they provide greater latitude in dealing with internal economic shocks. That said, this does not mean exchange rate volatility can’t be a problem. As Sternberg points out, currency depreciations can reduce investment, especially in developing countries.
Domestic and International Monetary Stability
The current discussion over the strong dollar is reminiscent of the monetary policy discussions of the mid-1980s. In the early years of that decade, Fed Chair Paul Volcker famously pursued a tight monetary policy to end the Great Inflation. Volcker’s actions, along with large budget deficits under President Reagan, caused U.S. interest rates to rise. The dollar appreciated steeply against the other major currencies of the world, and the U.S. began to run large deficits, especially against Japan.
These dynamics are similar to what we see today. After initially hesitating to take inflation seriously in 2021, the Fed raised its target interest rate, the federal funds rate, dramatically in 2022 and 2023 to quell inflation. The U.S. has also run large budget deficits under both Presidents Trump and Biden. These factors have contributed to higher U.S. interest rates and a stronger dollar.
Had the Fed raised the federal funds rate in a timelier manner when responding to both the Great Inflation and the recent inflation surge, it would not have had to resort to such steep interest rate hikes. The interest rate differential between the U.S. and the rest of the world would have also been smaller, so there would have been less volatility in the dollar’s exchange rate.
Stanford University economist John Taylor has argued that if major countries like the U.S., members of the Eurozone, and Japan each committed to a rules-based strategy to deal with domestic stability, greater international monetary stability would result. Taylor’s approach would require some international cooperation, but an individual country’s central bank would still be able to choose the monetary policy strategy it thinks is best. This approach would also keep the benefits of floating exchange rates.
Observers are right to worry about big swings in exchange rates. However, the best way to produce international monetary stability would be for the world’s major countries to get their domestic monetary affairs in order first.
Originally published by the Mecatus Center. Republished with permission.
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