ABA Banking Journal - November 2008 - (Page 100) briefing The Economy EUGENIO J. ALEMAN Vice-President and Senior Economist, Wells Fargo Corporation What a stronger dollar doesn’t mean THE OTHER DAY SOMEBODY ASKED ME IF I thought the U.S. dollar would continue to depreciate or remain weak. My answer was: without any doubt, yes! However, since the financial crisis worsened in August, the U.S. dollar has gained versus almost all world currencies. Some may argue that a recovery in the U.S. dollar indicates that the U.S. economy is not in such bad shape. While it is true that the U.S. dollar has appreciated against other currencies, especially the Euro and emergingmarket currencies, the truth is that it is not because the U.S. is better now. Rather, it is because markets are finally coming to terms with the fact that the rest of the world is in worse shape than originally thought. Thus, the U.S. dollar appreciation just looks like an imaginary oasis in the middle of the desert. The fact is that since the financial crisis erupted last year, pundits argued that the rest of the world had been able, this time around, to de-link from the U.S. economic troubles. Thus, markets were betting that the U.S. economy was the only one going down in this cycle. Starting in August of this year, however, this perception started to change and capital started to leave other countries and come back into the U.S., thus helping the U.S. dollar appreciate versus other currencies. Some of the most affected currencies have been those of Latin America, which are highly dependent on commodity prices. The appreciation of the U.S. dollar (right chart), as well as the ensuing slowdown in world demand, has put downward pressure on commodity prices, including oil, and these countries’ currencies have been in a free-fall. Thus, a more expansive monetary policy in the U.S. is having just the opposite effect on the U.S. dollar than what economic theory would suggest. But this is not because our situation has improved; it is because everybody else’s has deteriorated. In the foreseeable future, however, we can expect the U.S. dollar to remain weak, as the Federal Reserve continues to inject liquidity into the U.S. financial market. At the same time, we should not expect lower interest rates any time soon even if the Federal Reserve continues down this path. It is clear that liquidity, or the lack thereof, or the opportunity cost of lending, is being measured more by LIBOR than by the Federal Funds rate. And so far, the Federal Reserve has not been successful in affecting the behavior of LIBOR (left chart), which shows the severity of the worldwide flight to quality and severe risk aversion of investors. BJ Basis Points 400 350 300 250 200 150 100 Spread between LIBOR and Treasury Bills (3 month maturities) AIG Assisted WaMu Fails Trade weighted dollar index 130 Northern Rock Assisted Countrywide Assisted BearStearns Fell IndyMac Fails 120 100 100 90 50 0 9/1/2005 9/1/2006 9/1/2007 9/1/2008 Source: Federal Reserve & British Bankers Association 80 2001 2002 2003 2004 2005 2006 2007 2008 Source: Federal Reserve 100 NOVEMBER 2008/ABA BANKING JOURNAL www.ababj.com/subscribe.html http://www.ababj.com/subscribe.html
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