In circumstances where deflation is the primary concern, measures to weaken a country's currency are steps in the right direction because they help to offset forces of contraction and further acceleration of deflation. Policymakers are far more accustomed to fighting inflation; for that, a stronger currency is better. U.S. policymakers are breaking new ground with important reflationary measures to move the economy onto a path of sustainable recovery. If policymakers in Europe and Japan follow their lead, we could see a global recovery by 2004.

Moving to Preempt Deflation

On May 6, the Federal Reserve took a big step toward constructive reflation for the United States by emphasizing the threat of deflation as a reason for enacting a bias toward further easing. In "Fed speak" the message, echoing the concerns Chairman Greenspan expressed a week earlier in testimony to the House Committee on Financial Services about possible deflation was: "The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pick-up in inflation from its already low level." In case anyone took the Fed's characteristic understatement too literally, the next day the Washington Post carried this headline on the front page of the paper attached to its article by John Berry, a longtime Fed watcher: "Fed Fears a Spiral of Falling Prices." In short, the Fed signaled markets that it was aiming to stop deflation at the right time--before it starts.

The Fed's revolutionary statement in a world of inflation-obsessed central bankers apparently baffled many observers. The next day, the Financial Times of London printed an incredible blooper on its front page: "Fed Holds Rates But Warns of Inflation Risk." Old habits die hard and apparently most headline writers can only conceive of a central bank worrying about inflation. The Fed's expression of concern about possible deflation was revolutionary and constructive.

Less noticed at first was the response of the U.S. Treasury, the repository of final authority on America's exchange rate policy, which chimed in to underscore the Fed's virtuous plea for a weaker dollar. Almost simultaneously with the Fed's May 6 announcement of its heightened concern about deflation, Treasury secretary John Snow appeared in an interview televised on CNBC. Said Snow, "It has been our policy for many years to support a strong dollar. But the dollar's value is best set in an open, competitive currency market with minimal intervention."

The message was pretty clear. When a U.S. Treasury secretary operating in a disinflationary world and in an economy with a current account deficit at 5 percent of GDP presses to let markets determine exchange rates, he is calling for a weaker dollar. The U.S. aim, for now, is essentially to abandon its role as the world's only locomotive of demand growth. The "minimal intervention" portion of Secretary Snow's message was directed especially at Japan and China, whose governments have been aggressively buying dollars to prevent an appreciation of their currencies that would give an additional competitive edge to U.S. products selling in world markets.

At first, the financial press missed what amounted to a joint Fed-Treasury announcement that the United States had embraced a weaker dollar as a reflationary measure to support a U.S. economic recovery. The press reports did not pick up on the significance of Secretary Snow's statement on exchange rates until later in the week when he repeated it.

Market Response

The markets, however, did not miss the message coming from Greenspan and Snow. The dollar fell sharply against most currencies--especially the euro and the Canadian dollar--but after a few days passed, it also started to fall against the yen. The drop of the dollar was encouraged on May 8 when the still inflation-obsessed European Central Bank decided at its policy meeting to leave its interest rate target (set at double the 1.25 percent target of the Fed) unchanged, while professing its comfort with a stronger euro.

As markets realized that the United States had signaled a desire to export some deflation while the ECB professed willingness to import some deflation, the euro strengthened further. The absurdity of a region like Europe nearly in recession welcoming a deflationary impulse in the form of currency appreciation produced other market responses. The German stock index, which had been rising, started to fall, while the U.S. S&P 500 Stock Index continued the rise it had begun early in April at the end of the war in Iraq.

Not only did the U.S. stock market outperform the European stock market after the U.S. signaled its comfort with a weaker dollar, but U.S. long-term interest rates actually fell relative to European long-term interest rates. With so much excess capacity in the world economy, a weaker dollar presented no additional inflationary risk for the United States. In fact, the Fed's signal of a concern about deflation convinced market players that there would be no rate increase for a long time, until longer-term U.S. rates fell. Beyond that, many U.S. investors had been positioned for higher long-term U.S. rates so that the Fed's signal about deflation forced a scramble to readjust positions by buying back long-term treasuries. No one seemed worried about carping from (now silent) budget deficit Cassandras wailing that tax cuts and higher budget deficits would lead to higher interest rates.

Why the Fed Changed Course

Many close observers were caught off guard by the Fed's specific statement of concern about "an unwelcome substantial fall in inflation." Before the Fed's statement, the prevailing view had been to note that, while U.S. inflation rates were low, deflation--falling domestic prices--had not yet arrived. While this observation was broadly true, it failed to recognize that a continued drop in inflation could gain momentum and leave the Fed powerless to stimulate the economy at very low levels of interest rates. A fed funds rate of 1.25 percent means a real, or inflation-adjusted interest rate of zero, if markets expect inflation of about 1.25 percent. If inflation continues to fall, say to zero, a crude measure of the real interest rate actually rises to 1.25 percent, given a 1.25 percent fed funds rate. If falling inflation causes investors to adjust expected inflation even lower, say to minus 2 percent, then even a Fed target interest rate of zero means an expected real interest rate of plus 2 percent. When deflation taxes take hold, it discourages spending and investment which, in turn, cause deflation to intensify. That is the downward spiral of prices trumpeted on the front page of the May 7 Washington Post.

That downward spiral can doom an economy to years of recession and low growth--Japan's experience over the past decade. A deflationary spiral is a situation so bad that no sensible central bank ought to get anywhere near it. And so it is necessary to move proactively, as the Fed has done, to head off a further move toward deflation before it actually starts to appear.

There are plenty of other reasons for the Fed to indicate to markets that it is either going to hold short-term interest rates steady for a long time or is prepared to cut even further. First, its favorite measure of inflation--the core personal consumption deflator--is falling rapidly. The latest numbers showed an annualized inflation rate at 0.9 percent for the three months ending in March, down sharply from a 1.5 percent year-over-year rate. A measured inflation rate below 1 percent in effect suggests zero inflation because Fed studies about price measurement errors show that inflation measures have an upward bias.

Beyond that, the early economic indicators following the war in Iraq were not good. Chairman Greenspan and other Federal Open Market Committee members had emphasized the hope that the U.S. economy would recover rapidly after the war and, more specifically, that a sustainable recovery would be led by an investment rebound in the second half of this year. However, in the weeks following the war, the signals on the investment rebound started to turn negative. The preliminary report on first quarter GDP showed that the brief rebound in business fixed investment to a positive 2.3 percent annual rate at the end of last year relapsed to a negative 4.2 percent annual rate in the first quarter of 2003. Meanwhile, a more current survey of investment spending plans conducted by Goldman Sachs showed that plans for spending on information technology, a key sector, deteriorated sharply between February and April of this year. In February, 23 percent of survey respondents indicated that they expected to see an acceleration in their IT spending in the second half of 2003. By April, only 4 percent expected to see an acceleration in IT spending by the second half of 2003.

Faced with fading hopes for a second half recovery in investment spending, the Fed chose on May 6 to clearly signal its intention to hold rates low for a long time and to ease further in the absence of convincing signs of a sustainable recovery. The focus on weaker inflation data as a rationale for further easing was both revolutionary and convenient. It was revolutionary because for the first time it indicated that the Fed was prepared to base policy on the need to move proactively to avoid deflation. Beyond that, weaker inflation data gave Chairman Greenspan a graceful excuse to abandon the position he staked out in February of this year that the passing of the war would coincide with an improving U.S. economy.

Why the Treasury Followed Suit

The Bush administration's decisive move toward a weaker dollar policy was based on concerns about the outlook for the U.S. economy and on a thorough analysis available from the Fed's model showing the measures that would prove most effective in stimulating higher U.S growth and reflation. As the Fed runs out of room for further easing and as Congress pares back the tax cuts requested by the president, the usual levers of monetary and fiscal policy have become stuck. In that environment, and with the decline in oil prices limited to about $10 a barrel, a weaker dollar wins hands down as the best policy measure. The Fed's model suggests a 10 percent decline in the real dollar (that is, a drop in the dollar's value 10 percent beyond the change in the inflation differential between the U.S. and its trading partners) adds 0.4 percentage points to growth during the first year after the dollar decline and another 1.2 percentage points to growth in the second year. Given that a persistent decline in the dollar got underway only in September 2002, it is pretty clear that a continued drop in the dollar would be required to help growth in 2004, an election year.

Size and Effects of the Dollar's Slide

The dollar probably has a good deal further to slide. Currency moves tend to be of long duration. The dollar rose by nearly 50 percent from its low in 1995 to its high early in 2002. Since then, the drop has been only by about 10 percent, and so a drop in the trade-weighted dollar by another 10 or 20 percent would not be at all out of the ordinary. Whether the dollar weakens even further depends on the response of other countries.

The effect of a weaker dollar will be to shift demand onto U.S. producers by making U.S. exports relatively less expensive in world markets and making imports relatively more expensive in U.S. markets. Given the existence of considerable excess capacity, the weaker dollar will, initially at least, produce little, if any, additional inflationary pressure. Instead, its main effect will be to drive a beneficial increase in real output. The confidence that a weaker dollar will not boost U.S. inflation, and in fact, may not arrest disinflation for some time, has been signaled by a continued drop in U.S. long-term interest rates since the announcement of the new dollar policy.

Whether the U.S. reflationary effort at dollar weakening helps the world economy depends on the response of policymakers abroad to a weaker dollar. The appropriate response from foreign central banks is to avoid intervention to prevent the dollar from depreciating and to cut interest rates further to help stimulate demand in their own economies. This is particularly true of the European Central Bank, which has been reluctant to ease until its inflation rate gets below 2 percent. A strengthening euro will quickly push the Europe-wide inflation rate (currently at 2.1 percent) well below 2 percent and should usher in another 100 basis points of easing by the European Central Bank by this fall. If that occurs, the U.S. movement toward reflation will have triggered a European move toward reflation and progress toward absorption of global excess capacity, which is the key to sustainable global economic recovery.

A weakening U.S. dollar presents special problems for Japanese policymakers since interest rates in Japan are already at zero. The initial response of the Japanese was the wrong one. A few days after the Fed decision and Treasury announcement leading to a weaker dollar, the Japanese elected to spend between $6 and 8 billion intervening to support the dollar and to resist yen appreciation. It would be more constructive if the Japanese took the upward pressure on their currency as a sign of the need for more aggressive reflationary measures by the Bank of Japan. Such measures would include setting a target for a positive inflation rate and aggressive purchases of assets not usually purchased by the Bank of Japan to signal their determination to achieve that target.

A pragmatic reason for the Japanese to adopt a more reflationary policy is that intervention will not work. If, at the end of May or June, when Japan reveals that its total currency intervention so far this year has cost above $20 or $30 billion while the pressure for the Japanese currency to appreciate continues, markets will conclude that the Japanese government's resistance of yen appreciation is futile. After all, Japan's currency is appreciating in a deflationary world because Japan is the most deflationary country in the world. If Japan escapes the questionable distinction of being the most deflationary country in a deflationary world, its currency eventually will weaken, as Japan desires, and Japan will experience a constructive reflation that will help lead to a sustainable economic recovery in Japan and in the world economy.

A Policy Revolution

The clear decision by the Federal Reserve to resist deflation, coupled with an announcement by the Treasury to seek a reflationary weakening of the dollar, constitutes a major step toward a sustainable economic recovery in the United States and, with the right responses abroad, a global economic recovery. Approaching the limits of traditional interest-rate cutting monetary policy, and stymied by a U.S. Senate badly confused about the need for tax cuts to stimulate growth, the Bush administration chose the only alternative to promote growth--a weaker dollar. Just as tax cuts that drive up the budget deficit for a time make sense in a post-bubble economy burdened with excess capacity, so too does a weaker currency make sense in a world threatened with growing deflationary pressure. The Bush administration has learned these lessons and turned them into action. Let's hope that the U.S. Senate and central banks in Europe and Japan do the same thing. If that happens, a U.S. recovery will expand into a global recovery.

John H. Makin is a resident scholar at AEI.