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THE POSITION OF THE DOLLAR Remarks by Frederick H. Schultz Vice Chairman, Board of Governors of the Federal Reserve System at the 41st Assembly for Bank Directors Southampton Princess, Bermuda Friday, May 23, 1980 A REMARKABLE PHENOMENON OF THE PAST COUPLE OF YEARS HAS BEEN THE UPSURGE IN PUBLIC ATTENTION PAID TO DEVELOPMENTS IN WHAT WAS FORMERLY A RATHER ARCANE AREA, NAMELY, THE FOREIGN EXCHANGE MARKETS. AT CERTAIN TURBULENT TIMES THE STATE OF THE DOLLAR IN THE DAY'S TRADING HAS BEEN THE HEADLINE OR, AT LEAST, THE FEATURE TV STORY ON THE EVENING NEWS. REPORTS ON THE DOLLAR'S FATE HAVE BECOME A STAPLE ON THE MORNING NEWS WE HEAR ON OUR CAR RADIOS AS WE DRIVE TO WORK. We HEAR EARLY RESULTS FROM TOKYO TRADING ON OUR CLOCK RADIOS AS WE GO TO BED. Wh y all this OTHER CURRENCIES? attention t o t h e d o l l a r 's v a l u e in t e r m s of 1 THINK THAT IT IS BECAUSE LARGE AND RAPID CHANGES IN THE FOREIGN EXCHANGE VALUE OF A CURRENCY ARE OFTEN AN INDICATION OF CHANGES IN PUBLIC CONFIDENCE IN THE GOVERNMENT'S ECONOMIC POLICIES. THUS, THE SUBSTANTIAL DEPRECIATION OF THE DOLLAR IN .1977-78, AND THE RE-EMERGENCE OF HEAVY SELLING PRESSURE ON THE DOLLAR IN LATE SUMMER OF 1979 WERE SIGNALS THAT THE FINAN CIAL MARKETS THOUGHT THAT U.S. ECONOMIC POLICY WAS FAILING TO MAKE PROGRESS IN DEALING WITH THE MAJOR ECONOMIC PROBLEM OF OUR TIME, INFLATION. AT THE SAME TIME THAT A SUBSTANTIAL DEPRECIATION OF A CURRENCY OVER A SHORT TIME PERIOD MAY REPRESENT A PUBLIC VOTE OF NO-CONFIDENCE ON INFLATION POLICY, THE DEPRECIATION ITSELF MAY - ACTUALLY WORSEN INFLATION — This happens 2 - OR AT LEAST APPARENT INFLATION. principally because a depreciation of the dollar RAISES THE PRICE OF GOODS IMPORTED INTO THE UNITED STATES FROM FOREIGN COUNTRIES. THE INCREASES IN PRICES OF IMPORTED GOODS RAISE THE GENERAL PRICE LEVEL OF GOODS AND SERVICES PURCHASED BY U.S. CONSUMERS. THE RESULTING INCREASE IN THE PRICE LEVEL, OCCURRING OVER A PERIOD OF, SAY, ONE MONTH, IS THEN FREQUENTLY MULTIPLIED BY 12 IN NEWS REPORTS TO GIVE AN APPARENTLY SUBSTAN TIAL WORSENING OF THE ANNUAL RATE OF INFLATION. AND THERE IS A DANGER THAT THIS APPARENT ACCELERATION OF INFLATION MAY GET BUILT INTO EXPECTATIONS, CAUSING DOMESTIC WAGE EARNERS AND PRODUCERS TO TRY TO RAISE THEIR OWN WAGES AND PRICES EVEN FASTER. F inally, the announcements of several policy actions in RECENT YEARS, INCLUDING SOME BY THE FEDERAL RESERVE, HAVE CITED THE WEAKNESS OF THE DOLLAR AS ONE OF THE MOTIVES FOR THE ACTIONS. All of th e s e factors have combined, I t h i n k , to make the general PUBLIC MUCH MORE INTERESTED AND AWARE OF THE FOREIGN EXCHANGE VALUE OF THE DOLLAR. O n e REACTION TO THIS INCREASED AWARENESS OF FLUCTUATIONS, PARTICULARLY DEPRECIATIONS, IN THE DOLLAR'S VALUE HAS BEEN A SUG GESTION THAT WE "RETURN TO THE GOLD STANDARD." THE GOLD STANDARD CAN MEAN DIFFERENT THINGS. NOW, A RETURN TO It COULD MEAN SIMPLY RE-ESTABLISHING A COMMITMENT ON OUR PART TO CONVERT ON DEMAND HOLD INGS OF DOLLARS OF FOREIGN MONETARY AGENCIES INTO GOLD AT SOME - FIXED PRICE. This could FIXED EXCHANGE RATES. 3 - serve as f o r r e -e s t a b l i s h i n g a basis O r IT COULD MEAN RE-ESTABLISHING A FULL GOLD STANDARD, ENCOMPASSING FREE CONVERTIBILITY OF CURRENCY INTO GOLD BY THE GENERAL PUBLIC, EITHER IN THE UNITED STATES ALONE OR IN ALL COUNTRIES. In THE FACE OF OUR RECENT INFLATION EXPERIENCE, A FULL GOLD STANDARD HAS SUPERFICIAL APPEAL — SURELY THE PURCHAS ING POWER OF THE DOLLAR WOULD HAVE DECLINED LESS IF THE DOLLAR HAD BEEN TIED TO GOLD. INTO GOLD — F ixed THE APPEAL OF LIMITED, EXTERNAL CONVERTIBILITY THAT IS, FIXED EXCHANGE RATES — exchange rates are unlikely to w o r k IS MUCH LESS CLEAR. where governments are FREE TO MANAGE THEIR CURRENCIES INDEPENDENTLY AND, THUS, TO PRO DUCE DIFFERING RATES OF INFLATION IN DIFFERENT COUNTRIES. In SUCH CIRCUMSTANCES, DIFFERENCES IN THE EXTERNAL AND INTERNAL PURCHASING POWERS OF CURRENCIES WILL PRODUCE IRRESISTIBLE PRESSURES FOR CHANGE. E ither the c a l l y , or s o -c a l l e d restrictions services , and accounts of the fixed will be capital as through the disintegration exchange use of rates imposed governments of direct the fixed will be on try the free trade to balance controls. exchange This rate periodi changed of their is t h e goods, external lesson regime in t h e gold standard LATE 1960's AND EARLY 1970'S. Se r i o u s problems would exist with a full — THAT IS, THE FREE CONVERTIBILITY OF CURRENCY INTO GOLD BY THE public. First, there would be the APPROPRIATE INITIAL PRICE OF GOLD. problem of establishing an A PRICE THAT WAS SET TOO HIGH - 4 - COULD IMPLY A RAPID INCREASE IN THE PRICE LEVEL AS PEOPLE SOLD THEIR GOLD TO THE GOVERNMENT FOR DOLLARS (AND THEN SPENT THOSE DOLLARS ON GOODS AND SERVICES). A PRICE THAT WAS SET TOO LOW COULD MEAN A DRASTIC DEFLATION/DEPRESSION AS PEOPLE TURNED THEIR DOLLARS IN FOR GOLD (AND STOPPED BUYING GOODS AND SERVICES). Se c o n d , there would be the PRICE OF GOLD OVER TIME. problem of maintaining an appropriate VARIATIONS IN THE REAL COSTS OF PRO DUCING GOLD, OR VARIATIONS IN THE DEMAND FOR GOLD AS AN INDUSTRIAL COMMODITY WOULD LEAD TO ARBITRARY VARIATIONS IN THE QUANTITY OF DOLLARS IN CIRCULATION AND, HENCE, IN THE GENERAL PRICE LEVEL. T h e ULTIMATE AIM OF THOSE WHO SUPPORT A RETURN TO A FULL GOLD STANDARD IS TO END INFLATION. I SUPPORT THIS END BUT BELIEVE THAT IT COULD BE BETTER REACHED UNDER EXISTING INSTITUTIONS. I WILL RETURN TO THE SUBJECT OF APPROPRIATE ANTI-INFLATION POLICY SHORTLY. AS FAR AS THE EXCHANGE RATE SYSTEM IS CONCERNED, I BELIEVE THAT, BY AND LARGE, THE SYSTEM OF MANAGED FLOATING HAS SERVED US well. Ex c h a n g e rates over the longer run have reflected fundamental ECONOMIC TRENDS, AND EXCESSIVE SHORT-RUN MOVEMENTS HAVE BEEN AMENABLE TO CONTROL BY COORDINATED EXCHANGE MARKET INTERVENTION BY CENTRAL BANKS. Ov e r the past seven years of floating, the dollar has DEPRECIATED AGAINST SOME MAJOR CURRENCIES, APPRECIATED AGAINST - 5 - OTHERS, AND HAS SHOWN LITTLE NET CHANGE AGAINST STILL OTHERS. Th e largest and the the It a l i a n depreciations Ge r m a n markj lira and have been against Sw i s s the the largest appreciations the Ca n a d i a n have dollar; against THE YEN IT HAS CHANGED BY LESS THAN 10 been against sterling ON PE R C E N T . franc and AVERAGE, ACCORDING TO THE INDEX WE USE AT THE FEDERAL RESERVE BOARD, THE DOLLAR HAS DEPRECIATED BY 13 PERCENT SINCE FlARCH 1973 AGAINST 10 LEADING FOREIGN CURRENCIES. Ov e r a of y e a r s , the period major factor determining the LEVEL OF EXCHANGE RATES IS DIFFERENCES IN INFLATION RATES AMONG COUNTRIES. The CURRENCIES OF HIGH INFLATION COUNTRIES MUST DEPRE CIATE IN ORDER THAT THE EXPORT PRICES OF THOSE COUNTRIES MAY REMAIN COMPETITIVE WITH THOSE OF LOW INFLATION COUNTRIES. THE CONSUMER PRICE LEVEL OF THE UNITED STATES HAS RISEN BY CENT MORE THAN THAT OF S-WITZERLAND, AND Ge r m a n y , the two countries against 32 whose HAS RISEN BY 37 39 PER PERCENT MORE THAN THAT OF currencies SHOWN THE GREATEST DEPRECIATION OVER THIS PERIOD. U.S. CPI 1973, SlNCE MARCH the dollar has SIMILARLY, THE PERCENT LESS THAN THE ITALIAN CPI, AGAINST WHICH CURRENCY THE DOLLAR HAS SHOWN THE LARGEST APPRECIATION. Wh i l e tant relative inflation rates are thl single most impor DETERMINANT OF EXCHANGE RATES OVER A LONG PERIOD OF TIME, OTHER FACTORS ALSO INFLUENCE EXCHANGE RAILS, PARTICULARLY OVER A SHORTER TIME. fN THE VERY SHORT RUN, IT IS EXPECTATIONS ABOUT THE FUTURE VALUES OF BASIC ECONOMIC FACTORS — OFTEN REFERRED TO AS - "PSYCHOLOGICAL" FACTORS ~ 6 - WHICH DOMINATE MOVEMENTS IN EXCHANGE RATES. Pe r h a p s the most important of these other FACTORS IS COUNTRIES' CURRENT ACCOUNT BALANCES — economic THE EXCESS OR DEFICIENCY OF RECEIPTS FROM FOREIGNERS ARISING FROM THE EXPORT AND IMPORT OF GOODS AND SERVICES. BUT EVEN HERE, THERE IS NO SIMPLE, DIRECT RELATIONSHIP BETWEEN CONTEMPORANEOUS CURRENT-ACCOUNT BALANCES AND EXCHANGE RATES. TIVELY STEADY IN RECORD PLUS in U.S. 1976 FOR EXAMPLE, THE DOLLAR REMAINED RELA AND EARLY 1977 DESPITE THE EMERGENCE OF A CURRENT-ACCOUNT DEFICIT, FOLLOWING A SUBSTANTIAL SUR 1975. This deficit was generally regarded at the time as A SHORT-TERM CYCLICAL PHENOMENON, SINCE THE RAPIDLY FROM THE PARTNERS. 1974-75 U.S. RECOVERED MORE RECESSION THAN DID ITS MAJOR TRADING THE DEFICIT WAS EXPECTED TO BE REDUCED WHEN OUR TRADING PARTNERS' EXPANSION CAUGHT UP WITH OUR OWN. It WAS NOT UNTIL LATE 1977, WHEN FORECASTS BEGAN CIRCULATING SHOWING A U.S. DEFICIT FOR 1978 ABOUT AS LARGE AS THAT OF 1977, THAT THE MARKET BEGAN TO SEE THE U.S. DEFICIT AS SOMETHING MORE THAN TEMPORARY, REQUIRING A SIGNIFICANT DEPRECIATION OF THE DOLLAR TO CORRECT; AFTER THAT CHANGE IN SENTIMENT, THE DOLLAR BEGAN TO DROP SHARPLY. end of September 1977 DEPRECIATED BY ABOUT to the end of December 15 PERCENT ON AVERAGE. 1978, In FROM THE the dollar 1979, THE DOLLAR SHOWED LITTLE NET CHANGE, DESPITE A SUBSTANTIAL IMPROVEMENT IN OUR CURRENT ACCOUNT TO NEAR BALANCE. APPARENTLY THEN, THE IMPACT OF - 7 - THE CURRENT ACCOUNT BALANCE ON THE EXCHANGE RATE DEPENDS ON WHETHER THE MARKET VIEWS A DEFICIT OR SURPLUS AS TEMPORARY OR AS REQUIRING AN EXCHANGE-RATE CHANGE TO ADJUST THE BALANCE TO A SUSTAINABLE POSITION. Y e t ANOTHER IMPORTANT ECONOMIC FACTOR IN THE DETERMINA TION OF EXCHANGE RATES IS SHORT-TERM INTEREST RATE DEVELOPMENTS. He r e again there is n o simple, direct relationship. Wh e r e inter- EST-RATE DIFFERENTIALS MOVE SO AS TO JUST COMPENSATE FOR EXPECTED INFLATION DIFFERENTIALS, THERE IS NO NOTICEABLE EFFECT ON EXCHAMGE rates. Wh e r e i n t e r e s t -r a t e changes are taken as indicators of CHANGES IN MONETARY POLICY, HOWEVER, EFFECTS ON EXCHANGE RATES CAN BE DRAMATIC. THIS SEEMS TO HAVE BEEN THE CASE IN THE RECENT PERIOD FROM MID-FEBRUARY THROUGH EARLY APRIL AS U.S. SHORT-TERM INTEREST RATES SOARED AND THE DOLLAR APPRECIATED BY 10 PERCENT. Th e n , as interest rates subsequently plummeted, the BY 8 PERCENT FROM EARLY APRIL TO MID-MAY. dollar dropped TOWARDS THE END OF THIS PERIOD, THE MARKET SEEMS TO HAVE REALIZED THAT THESE INTEREST RATE DECLINES DID NOT SIGNIFY A RELAXATION OF MONETARY POLICY BUT, RATHER, A REDUCTION IN THE DEMAND FOR MONEY AS ECONOMIC ACTIVITY in t h e U n i t e d St a t e s m i d -F e b r u a r y apparently declined t h r o u g h m i d -M a y , t h e d o l l a r NET DECLINE, DESPITE THE FACT THAT U.S. abruptly. showed In d e e d , essentially from no SHORT-TERM INTEREST RATES HAD DROPPED RELATIVE TO FOREIGN RATES BY A NET 5 PERCENT. As FOR THE OUTLOOK FOR THE DOLLAR, WE CAN BE REASONABLY OPTIMISTIC. U.S. INFLATION IS EXPECTED TO DECLINE OVER THE COURSE - OF THE NEXT YEAR. INTO DEFICIT IN AND THE 1980 8 - U.S. AS A RESULT SHOULD IMPROVE SIGNIFICANTLY IN CURRENT ACCOUNT, WHILE MOVING OF.1979's OPEC OIL PRICE RISE, 1981r THE CURRENT-ACCOUNT BALANCES OF THE OTHER TWO LARGEST ECONOMIES, JAPAN AND GERMANY, ARE EXPECTED TO REMAIN IN SUBSTANTIAL DEFICIT OVER THE PERIOD. IN 1980-81 THESE CIRCUMSTANCES, THE DOLLAR SHOULD AT LEAST HOLD ITS OWN IN EXCHANGE MARKETS, ON AVERAGE, OVER THE NEXT YEAR OR SO, IF THERE ARE SHORT-RUN PERIODS WHEN THE DOLLAR MOVES SO FAR AS TO BE CLEARLY OUT OF LINE WITH ECONOMIC FUNDAMENTALS, WE WILL DEAL WITH THIS BY INTERVENING IN THE EXCHANGE MARKETS TO THE APPROPRIATE EXTENT. OVER THE LONGER RUN, AS I HAVE SAID, WHAT HAPPENS TO THE DOLLAR ABROAD IS MAINLY A CONSEQUENCE OF WHAT HAPPENS TO THE DOLLAR AT HOME, THAT IS, OUR DEGREE OF SUCCESS IN DEALING WITH INFLATION. It IS THIS PROBLEM TO WHICH I WILL NOW TURN. Ev i d e n c e has been mounting in r e c e n t weeks THAT OUR ECONOMY HAS ENTERED A PERIOD OF DOWNTURN. and months A t THE SAME TIME, INFLATIONARY PRESSURES REMAIN DANGEROUSLY STRONG. THIS SEEMING PARADOX POINTS UP THE COMPLICATED NATURE OF OUR INFLATION PROBLEM. THE EXISTENCE OF EXCESSIVE DEMAND PRESSURES HAS FOR SOME TIME BEEN ONE ASPECT OF THAT PROBLEM. THIS IS THE ALL TOO FAMILIAR STORY OF "TOO MUCH MONEY CHASING TOO FEW GOODS." WHEN OUR DEMAND FOR PRODUCTS EXCEEDS THE NATION'S CAPACITY TO PRODUCE - 9 - THOSE PRODUCTS, WE WIND UP BIDDING AGAINST EACH OTHER FOR THE As THINGS WE DESIRE. THIS PROCESS WORKS ITS WAY THROUGH THE ECONOMY, THE RESULT IS INFLATION. IF SO-CALLED "DEMAND-PULL" INFLATION IS THE MOST OFFCITED VARIETY, IT IS BY NO MEANS THE ONLY IMPORTANT ONE. "COST- PUSH" INFLATION AS WELL HAS BEEN ALL TOO FAMILIAR IN RECENT YEARS. Rising OPEC energy prices, caused nations, have pliers posed by the a dramatic unilateral actions example. Fe w , of the if a n y , s u p OF GOODS AND SERVICES HAVE ESCAPED THE PRESSURE TO INCREASE PRICES POSED BY THE NEED TO COVER THE RISING ENERGY COSTS OF DOING BUSINESS. — A SEEMINGLY ENDLESS PROLIFERATION OF REGULATORY BURDENS IMPOSED ON BUSINESS BY ALL LEVELS OF GOVERNMENT — A PERVASIVE EFFECT ON COSTS AND THUS ON INFLATION. HAS ALSO HAD THE WAGE AND PRICE DETERMINATION PROCESSES IN CERTAIN SECTORS OF OUR ECONOMY, THE APPLICATION OF MINIMUM WAGE LAWS TO OUR YOUNG PEOPLE, AND THE STRUCTURE AND OPERATION OF SOME OF OUR SOCIAL WELFARE PROGRAMS, ALL PROVIDE ADDITIONAL ILLUSTRATIONS OF FACTORS THAT, THROUGH THE "COST-PUSH" MECHANISM, GENERATE INFLATIONARY PRESSURES. Finally, factors" that and have indeed those we can identify what contributed to of all the major might inflation. industrial be called The U.S. countries "s t r u c t u r a l economy — — has BENEFITED ENORMOUSLY IN THE PAST FROM THE IMPROVED TECHNOLOGY AND GREATER EFFICIENCY THAT HAVE BEEN ASSOCIATED WITH NEW INVESTMENT IN PLANT AND EQUIPMENT. THE TENDENCY OF RECENT YEARS TOWARDS - 10 - SUBSTANTIALLY REDUCED SAVINGS AND INVESTMENT ON THE PART OF THE Am e r i c a n people has hurt our productivity HAMPERED OUR FIGHT AGAINST INFLATION. record a n d , thus, RELATIVE ADVANTAGES IN PRODUCTION NATURALLY CHANGE OVER TIME AND IT IS NOT A MATTER FOR CONCERN IF, FOR EXAMPLE, THE U.S. MORE COMPUTERS THAN IT ONCE DID. PRODUCES FEWER TEXTILES AND BUT SOME HAVE SUGGESTED THAT THERE HAS BEEN A SLACKENING IN THE OVERALL COMPETITIVE VIGOR OF Am e r i c a n labor and industry. On e theory is t h a t , a s the scope OF GOVERNMENT AND OF TAXATION HAVE INCREASED, THE COSTS OF FAILURE AND THE REWARDS OF SUCCESS HAVE BOTH BEEN REDUCED TO DANGEROUSLY LOW LEVELS. To THE EXTENT THAT THESE FACTORS ARE OPERATIVE, THEY ROB US OF THE PRICE-REDUCING OPPORTUNITIES INHERENT IN A COMPET ITIVE ECONOMY AND EXPOSE US FURTHER TO INFLATIONARY TENDENCIES. I EXPECT YOU WOULD AGREE WITH ME ~ CITE YOUR OWN FAVORITE ILLUSTRATIONS " COMPLICATED PROCESS. AGAINST IT. AND EACH OF YOU COULD THAT INFLATION IS INDEED A BUT THIS DOES NOT MEAN THAT WE ARE POWERLESS WE DO, HOWEVER, NEED A BROAD-BASED STRATEGY TO DEAL WITH INFLATION. FlRM MONETARY AND FISCAL POLICIES ARE, OF COURSE, THE ESSENTIAL INGREDIENTS IN DAMPENING "DEMAND-PULL" INFLATION. I CAN SPEAK MOST AUTHORITATIVELY ABOUT MONETARY POLICY: F e d e r a l R e s e r v e Sy s t e m h a s , as you know, been THE embarked on a firm ANTI-INFLATIONARY COURSE FOR SOME TIME; I CAN ASSURE YOU THAT WE INTEND TO PERSEVERE, BUT, AS MY REMARKS HAVE SUGGESTED, MACRO ECONOMIC POLICIES NEED TO BE SUPPLEMENTED BY ADDITIONAL MEASURES - 11 - AIMED AT THE COST-PUSH AND STRUCTURAL FACTORS THAT ARE CONTRI BUTING TO INFLATION. THERE ARE MANY OPPORTUNITIES IN THESE AREAS, BUT OUR MOST URGENT NEEDS, AS I SEE THEM, ARE (1) TO REDUCE THE SIZE OF GOVERNMENT IN THE U.S. ECONOMY AND INCREASE THE INCENTIVES FOR PRIVATE SAVINGS, INVESTMENT, MODERNIZATION, AND INNOVATION, (2) TO REDUCE SUBSTANTIALLY THE REGULATORY BURDEN NOW IMPOSED ON U.S. BUSINESS, (3) TO FURTHER DEVELOP A SYSTEM OF VOLUNTARY GUIDELINES THAT WOULD DISCOURAGE WAGE AND PRICE DEMANDS THAT ARE OUT OF LINE WITH THE GENERAL TENDENCIES IN THE ECONOMY, AND (4) TO CONTINUE TO REDUCE OUR DEPENDENCE ON IMPORTED OIL. In f l a t i o n has gathered momentum AND IT WILL TAKE TIME TO ERADICATE IT. over Ab o v e a l l , we will never be period of years I EXPECT THAT WE WILL WITNESS PERIODS OF ENCOURAGING PROGRESS ~ setbacks. a BUT ALSO UNEXPECTED quite sure what the future HOLDS IN STORE; NONETHELESS WE WILL NEED TO FORM JUDGMENTS, BOTH IN OUR OWN LIVES AS INDIVIDUALS AND ON NATIONAL POLICY. THE POSITION OF THE DOLLAR IN FOREIGN EXCHANGE MARKETS DESERVES OUR CLOSE ATTENTION AS WE GO ALONG. SHARP MOVEMENTS IN EXCHANGE RATES ONE WAY OR THE OTHER CAN, AS I HAVE NOTED, EXERT AN INFLUENCE ON THE FUTURE COURSE OF INFLATION. PERHAPS MORE IMPORTANT, THEY WILL SUGGEST A MARKET VIEW AS TO HOW MUCH PROGRESS IS BEING MADE IN THE FIGHT AGAINST INFLATION.
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