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The Myth of a Strong Dollar Policy
By Ben Craig and Owen Humpage
Introduction
A strong dollar policy is the yeti of economics. Despite occasional sightings, most recently by the National Association of Manufacturers, the American Farm Bureau, and the AFL-CIO, scientific evidence indicates that no such species exists. The U.S. Treasury, which sometimes hints that it harbors the beast, simply lacks flexible policy instruments with which to manage dollar exchange rates. To be sure, U.S. tax policies help create an investment climate that attracts (or deters) international financial flows, and those flows affect dollar exchange rates. Some observers, for example, maintain that tax reforms in 1981 encouraged financial inflows and bolstered the dollar's exchange value and that tax law changes in 1986 had just the opposite effect. The Treasury, however, does not—and should not— manipulate tax policies to manage the dollar. Treasury officials also occasionally comment on exchange rates and create temporary blips in the market, but official pronouncements cannot sustain an exchange value.
While the Federal Reserve has the policy instruments with which to pursue an exchange rate objective, doing so has one of two implications: Either the Fed achieves its exchange rate goal at the expense of its inflation objective, or the exchange rate target is irrelevant because maintaining the inflation objective also promotes the exchange rate goal. The Fed came to this realization gradually over the past 30 years, after repeated and largely unsuccessful attempts to influence exchange rates. Since the early 1990s, the Fed has generally eschewed exchange rate policy in favor of an inflation objective, leaving the highly efficient foreign exchange market to determine rates.
In this article, we describe the instruments available to the Treasury and to the Federal Reserve System for affecting exchange rates. We explain why Treasury interventions, which have no effect on the Federal Reserve's target for the federal funds rate, have very little, if any, effect on exchange rates. Then we discuss the dilemma that the Fed faces when it attempts to achieve two policy goals—an exchange rate objective and an inflation target—with monetary policy alone. We conclude with a note on the efficient nature of exchange markets. We begin, however, by explaining why the traditional metric for judging the dollar overvalued, or too strong, offers a poor description of its equilibrium.
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