The dollar’s decline is being driven by what everyone in global markets is now expecting: another round of so-called quantitative easing by the United States. In the next few weeks, the Federal Reserve is expected to inject vast sums of money into the economy in another attempt to spur growth....The great thing about expectations is that a policy can have an effect before it is implemented - the mere fact that the Fed is expected to announce a new round of expansion in November has been enough to help get the dollar down after its summer spike due to the Euro crisis.
Financial markets expect the Fed to announce at its meeting early next month that it will proceed with more quantitative easing, involving purchases of bonds, which reduces longer-term interest rates and puts further downward pressure on the dollar.
That worries other countries. A stronger United States economy is in everyone’s interest, but they fear that investors will flee America’s low interest rates and declining dollar and instead pour capital into their markets, overheating their economies and creating the types of asset bubbles in stocks and housing that burst with such devastating effects in the 1990s.
Already there is evidence of this: American investment in overseas stock funds, which was running at about $4 billion a month over the summer, has surged since Ben S. Bernanke, the Federal Reserve chairman, suggested the possibility of another round of quantitative easing at the end of August. About $19 billion has flowed into these funds since Aug. 1, according to TrimTabs, a funds researcher.
So, while I am concerned about whether pushing down long-term interest rates really will do much to stimulate investment (I in GDP), anticipation of the policy is already building in a stimulative effect through the exchange rate channel (and, moreover, the markets are speaking).
So, what of the worries of those "other countries" that financial inflows will "overheat" their economies? If they choose to hold their currencies down, that would be a problem; the solution is to allow them to rise. As Jim Hamilton writes at Econbrowser:
If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody. If other countries feel that easing is contraindicated for their domestic situation, then isn't that part of the case why the dollar needs to depreciate relative to their currencies, given the current economic conditions in the U.S.?Or, more bluntly, "the dollar may be our currency, but your problem." That, of course, is what Nixon's Treasury Secretary John Connolly famously said in 1971, as the Bretton Woods system collapse. While I doubt Tim Geithner would speak so directly today, perhaps we are indeed at the end of the so-called Bretton Woods II regime, as Tim Duy predicted recently (see also Ryan Avent and the amusingly hysterical Ambrose Evans-Pritchard).