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The Dollar Depreciates – And That’s a Good Thing

Summary:
Interesting to note that the dollar has declined in tandem with economic policy uncertainty, as measured by the Baker, Bloom & Davis index (and predicted by historical correlations). Source: FRED. Not all else is held constant. Expected inflation has risen since the election — about 0.8 ppts on the 5 year breakeven — and the real ten year interest rate has fallen: about 15 bps. That means the decline in the dollar’s value is over-explained. Real rates have fallen somewhat, despite rising expectations of a large fiscal package. Rising expected inflation is consistent with the dollar’s movement, although the increase has been almost 2 ppts since March of 2020. From my perspective, dollar depreciation is a good thing, regardless of source. A depreciated dollar will encourage expenditure

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Interesting to note that the dollar has declined in tandem with economic policy uncertainty, as measured by the Baker, Bloom & Davis index (and predicted by historical correlations).

Source: FRED.

Not all else is held constant. Expected inflation has risen since the election — about 0.8 ppts on the 5 year breakeven — and the real ten year interest rate has fallen: about 15 bps.

That means the decline in the dollar’s value is over-explained. Real rates have fallen somewhat, despite rising expectations of a large fiscal package. Rising expected inflation is consistent with the dollar’s movement, although the increase has been almost 2 ppts since March of 2020.

From my perspective, dollar depreciation is a good thing, regardless of source. A depreciated dollar will encourage expenditure switching to the extent that exchange rate pass through is high (which is higher if from monetary shocks). I think a decrease in economic policy uncertainty is a win regardless — and that seems to have been delivered by the Biden election combined with unified control of the legislative branch.

By the way, the increase in expected five year inflation is a positive insofar as it helps achieve the real rate necessary to equilibrate aggregate demand to aggregate supply (i.e., set the real ex ante rate at the natural rate).

Menzie Chinn
He is Professor of Public Affairs and Economics at the University of Wisconsin, Madison

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