Fed study: Limited impact of a weaker dollar

One of the interesting elements in the dollar’s recent decline is that few, if any, people are suggesting it is being driven by its perennial nemesis, the large trade deficit. Most recognize the divergence of monetary policy and the anticipated trajectory of interest-rate differentials are the significant forces driving the greenback lower. However, many expect the weakening dollar will shrink the U.S. trade deficit. Such hopes are likely misplaced.

In “Why a Dollar Depreciation May not Close the U.S. Trade Deficit,” in the June issue of the New York Federal Reserve’s Current Issues in Economics and Finance, Fed economists Linda Goldberg and Eleanor Wiske Dillion persuasively argued there are three mitigating factors that may limit the impact of the dollar’s decline on the U.S. trade imbalance.

First, because nearly all U.S. imports and exports (93 and 99 percent, respectively) are invoiced in dollars, a weaker dollar’s impact on import prices is less than it would otherwise (and for other countries) be.

By comparison, since the advent of the euro, the Eurozone and the EU countries have reduced their use of the dollar as an invoicing currency for intra-European trade: 54 percent of Eurozone imports and 59 percent of their exports are invoiced in euros. In trade with the U.S., however, the dollar is still predominantly used.

Studies also suggest a high percentage of traded goods in Asia, Latin America, and Australia are still invoiced in dollars. In Japan, for example, only 26 percent of imports and 38 percent of exports are invoiced in yen. The share of exports invoiced in dollars often widely exceeds the share of exports accounted for by the U.S., which means many countries are using the dollar even when the U.S. is not one of the trade partners.

Second, the article notes that foreign exporters’ long-term competitive strategies are aimed at preserving market share, which means they accept narrower profit margins by not passing through the costs of a weaker dollar to the U.S. The authors suggest this is largely a function of the large U.S. economy’s higher level of competitiveness.

But there is another possible explanation. U.S. businesses (and Anglo-American economies in general) rely more on the markets, rather than banks, for capital. This means the cost of capital for Anglo-American companies rises if they do not meet the markets’ quarterly earnings expectations. This makes them keen to protect profit margins and more likely to pass along adverse currency movements.

In Continental Europe and Japan, by contrast, companies are more reliant on banks for capital, and banks tend to be more patient than the markets. The corporate expansion strategy that follows from this capital distribution model encourages companies to protect market share, which, in the short-run, may mean accepting a profit squeeze to maintain a longer-term strategic position.

The third factor the authors examined was the value added to imports after these goods enter U.S. ports — specifically, storage, transportation, and marketing costs. These costs, which account for 30 to 50 percent of the final price (a notably larger percentage than in most other countries) for a wide range of U.S. goods, are denominated in dollars. Even without the other mitigating factors, this reduces the portion of the final price that is impacted, even in the best of conditions, by the vagaries of the foreign exchange market. This means the U.S. experiences less pass-through of currency movement to import prices than other countries.

The authors cite a 1975-2003 study that analyzed the impact of currency movements on import prices with a year lag. The average pass-through for OECD countries was estimated at 0.64 percent, which means a 1-percent change in currency prices generates an average 0.64-percent change in import prices, with a wide variance around the mean. In the Eurozone, the pass-through is estimated at a little more than 0.8 percent. In Japan, estimates vary between 0.57 percent and 1.0 percent, with the rate usually at the upper end of that range.

By contrast, the pass-through to import prices in the U.S. is estimated at 0.42 percent — and even this might exaggerate the pass-through in recent years. Since 1990, the degree of pass through has dropped to 0.32 percent in the U.S., which is well below the OECD average of 0.48 percent over the same period.

The dollar’s decline has been largely concentrated against a handful of major currencies. The Federal Reserve’s major currency trade-weighted index has fallen a little more than 11 percent since the beginning of last year, while its broader trade-weighted index has fallen by a more modest 8.5 percent. These indices give more weight to countries with which the U.S. trades more and less weight to countries with which the U.S. trades less. The broader the index, the more countries are included (which often means less-developed countries with currencies historically undervalued by purchasing power-parity models).

These arguments suggest the improvement in the U.S. trade balance, which contributed almost 1.5 percentage points to both Q2 and Q3 2007 growth, is more likely a function of growth differentials than the dollar’s decline. And through the early part of Q4 2007 import prices were still rising at a slower rate than domestic prices.