While just about everything in the U.S. has felt the brunt of the economic slowdown recently, the dollar has remained steadfastly strong.

Typically, a currency will weaken as a result of a slowdown in the economy like the U.S. has seen, but not this time. That may be because the government is maintaining a strong dollar policy, or it may be because the other major currencies in the global scenario are simply weaker than the dollar.


Lara Rhame
Economist
Brown Brothers Harriman

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Today's Daily Interview speaks with Lara Rhame, an economist and currency strategist at

Brown Brothers Harriman

, to get her take on the strong dollar and its consequences for the U.S. economy. Her bottom line? The relative strength of the U.S. economy will keep the dollar strong against the euro and the yen through year's end, although this may not necessarily be the best scenario for the economy.

The U.S. government currently supports a "strong dollar" policy. What does this mean and how does it affect the current economy, its recent downturn and the potential for a second-half recovery?

Rhame:

The current strong dollar policy is really the continuation of something that was put in place quite a long time ago. Five years ago,

Treasury Secretary Robert Rubin put that policy in place, and it's one of the few policies that the current government has maintained from that time.

The current strong dollar policy has corresponded with a period of an incredibly strong dollar, but this has not always been the case. In many ways, it has given the market the impression that policy makers have a very magical way of controlling the value of the currency, which is just not true.

As for how this policy has affected the current economy, it definitely has had a dampening effect on both our export growth and on our manufacturing sector. We've also now seen tertiary effects on international companies based in the U.S., trying to repatriate sales revenues and getting a double whammy from sales abroad falling as the global economy slows, and repatriating those assets at a much lower dollar value. So, we've actually had several different effects because of the strong dollar. These effects are always very lagging -- right now we may be seeing the cumulative effects of several years of an extremely strong dollar.

We've seen imports soar over the last three years, from 15% of GDP to over 18% of GDP now, and we've seen exports stay relatively flat at around 14% to 15% of GDP. This has given us a wider trade gap, and you can see this in a lot of different places.

Which leads us to the next question: Looking forward to the economic recovery predicted for the second half of this year, would a stronger dollar or a weaker dollar help to stimulate the economy and get it back on its feet?

Rhame:

Clearly a weaker dollar will give the economy much more of a boost. A weak currency acts on an economy in very similar ways to low interest rates -- one of the good things about that is that our goods would become relatively competitive with international goods. Not only would it allow our producers to compete on sales domestically, since things produced here wouldn't be as expensive relative to things we can import, it would also help our export sector.

On the negative side, it would probably give us somewhat higher inflation.

Which is a growing concern as the Fed continues to cut interest rates...

Rhame:

Right, though the Fed has made it clear that growth is a much more important factor to them than inflation, and that they view risks to growth as being much larger than the risk of inflation. I think that a part of that -- and one of the things that the Fed has said --is that a strong dollar helps to keep inflation under control. If we lose that, we may lose some scope for future Fed easing.

Considering the economic woes in Japan and the slowing economy in Europe, do you believe that the U.S. dollar is trapped into a position of strength?

Rhame:

In some ways. Interestingly, though, against the yen the dollar is not historically very strong. Against the euro and virtually every other currency but the yen, the dollar is near 15-year highs. We made some sideways motion against the yen for a little while, but we do expect the dollar to eventually strengthen further against the yen.

As for trading against the euro, overall the strength of the dollar has been undeniable. I think a lot of that has to do with international investors looking at the three key regions, those being the U.S., Europe, and Japan, and saying it's like three big ships out there and asking which one is sinking, which is going to stay afloat, which one has the best prospects going forward? And that, inevitably, ends up being the dollar most of the time. So, I think we're here to some extent because there's just nowhere else to go.

If a weaker dollar could help our economy, but the relative weakness of other currencies is keeping the dollar strong, might the government intervene to weaken our currency?

Rhame:

That's a really, really important question. When

Paul O'Neil

came in as Treasury Secretary, I was out there saying, "This is it, this is the end of the strong dollar policy. Forget it, it's over." I thought they would abandon it to help stimulate the economy, especially with manufacturing getting hit the hardest. And they haven't changed that policy at all.

If they do try to intervene, the only way they might do that would be through the Treasury and the mouthpiece of the Treasury. I don't see actual foreign exchange market transactions as being a possibility, simply because the U.S. tried that in the early 90's and it just didn't work.

I can envision two scenarios. In one, O'Neil backs off ever so slightly from the strong-dollar policy and the dollar just drops through the floor. I think this may be one issue that the Treasury may be worried about, that the strong-dollar policy has been so effective that any altering of that will give a very traumatic and pronounced reaction.

The other scenario that I could equally well envision is with the yen. I think that if the dollar goes to 140 yen, which is a distinct possibility, that exchange rate pair is politically sensitive, and you would have both sides of the Pacific screaming that this is out of whack. I can envision O'Neil coming out and calling for a strong dollar, but still allow for weakening against the yen, and nobody would pay attention to that because if you're a trader on Wall St. and you don't think that it's a good investment, then no matter what the Treasury Secretary says, you're not going to buy it.

Perhaps everybody views the Treasury as being too powerful in terms of setting rates. If the dollar naturally does start to weaken, for one reason or another, the Treasury Secretary coming out either for or against that just won't have much influence.

One last question. Bottom line it for our readers -- where are the dollar and the economy going from here?

Rhame:

The strong dollar right now is trading off of the international markets' expectations for a recovery in the second half of the year. International investors are not pricing in a recession, but they are pricing in not only still strong economic growth in the U.S., but a return to strong equity gains -- particularly given the fact that we know the European economy is going to slow and you've had Europe falling from 3% growth to 2% growth this year, and the U.S. going from 5% to 1.5% or 2%, that in theory should make the dollar much weaker.

That the dollar is not is reflecting the fact that investors feel like the U.S. productivity-wise is still the best, equity gains-wise is still the best, and feel that that really makes the U.S. the only model right now of solid growth, beyond the recent

dip

in economic activity, if you can call it a dip.

Bottom line -- I think that economic scenario will keep the dollar strong. We look for the dollar to move to 98 cents vs. the euro by the end of the year, and we think it will go to 140 yen by the end of the year.