Impact on the U.S. dollar

The best policy mix for a currency is arguably an expansionary fiscal policy, which stimulates growth, combined with tighter monetary policy, which stimulates foreign investment into dollar-denominated securities and raises the opportunity cost of being short the dollar.

This was the policy mix under President Ronald Reagan and Fed Chairman Paul Volcker in early 80s, which led to the dollar overshoot of the mid-80s. This was also the policy mix in Germany after the Berlin Wall fell and led to the super-Deutschemark of the early 90s, peaking in 1995. More recently, it is the policy mix that has helped the Canadian dollar generate its impressive performance in recent years.

As was seen in late August, the U.S. dollar is strongly influenced by market expectations regarding the outlook for monetary policy. When the market expects the Fed to reduce the pace of tightening, the dollar comes under strong downside pressure. And, when the market expects the Fed to accelerate the pace of tightening, the dollar finds better traction.

Hurricane Katrina could quite easily lengthen the duration of the tightening, as well as its magnitude, because of the threat to price stability imparted by higher energy prices. Thus, interest rate differentials appear dollar positive as investors must pay for the “privilege” of being short the U.S. dollar against most major foreign currencies. The question remains whether tighter monetary policy produces an offsetting negative dollar impact on weaker growth differentials.

The degree to which higher interest rates reduce U.S. economic growth will likely depend on continued flexibility of the U.S. economy and minimizing the second-round effects of Katrina on consumer spending, business confidence, and inflationary expectations.

Regarding the “twin deficits” problem, there is a similar quandary. Hurricane Katrina will certainly prompt growth in the fiscal deficit, which risks undermining confidence in Washington and may imply higher taxes at some future date. If second-round effects reduce U.S. economic growth, it could thereby lessen demand for imports.

The final answer to whether Katrina will be bad for the U.S. dollar will probably have to wait until the beginning of next year before it can be ascertained whether second round effects on U.S. growth fundamentals have been avoided. Until then, sentiment indicators will take on added importance in the financial markets.