Econ 101: Inflation, Exchange Rates and Commodities

Though I try and stick more to the local and the personal in this blog, I thought it might be a good time to try a little primer on international finance, as I just taught it in my international economics class. Call it the "what the heck is going on?" post.

I am going to borrow a pedagogical device right out of Krugman and Obstfeld's outstanding text and start with an asset either in Europe or the US. What determines the performance of this asset? Well, interest rates and inflation if you are investing domestically. If you are investing from abroad, however, exchange rates matter as well. But it is not what the state of the world today that matters most for the performance of an asset, it is what the state of the world will be in the future - when the asset matures - that matters most. Thus expectations about inflation and exchange rate movements matter a lot. This is why central banks have become more and more transparent: they are trying to manage expectations. This is also why central banks have become, first and foremost, inflation hawks: they want to guarantee low inflation lest investors get jittery.

So let's get back to that asset. Suppose you are in Europe and you have money to invest and you are thinking of investing in either a euro denominated asset or a US dollar denominated asset. If interest rates in the US are high, you might be tempted to invest in the dollar asset, to do so you want to sell euros and buy dollars so you can purchase the asset. Since many investors are making the same calculation the demand for dollars will be driven up and demand for euros will be driven down. This will lead to an appreciation of the dollar. Higher interest rates in Europe, all else equal, will have a similar effect: the euro should appreciate against the dollar (or dollar depreciation). Inflation in either zone will lower the real return on the asset and thus will have the same effect as lowering the nominal interest rate and thus high inflation in the US should lower the demand for dollar assets and lead to a depreciation of the dollar. Finally, expectations about exchange rates can lead to them being self-fulfilled: if you expect the dollar to depreciate this leads to a lower demand for dollar assets (because when it matures the dollars you get out are now worth less) and thus a lower demand for dollars and - hey presto! - a dollar depreciation.

With this basic framework in hand, it is not surprising that the US dollar has depreciated so remarkably over the last few years - the fed kept interest rates low which both lowered the return on dollar assets and caused a bit of concern about inflation. Here is a picture of the dollar-euro exchange rate for the last five years:



Commodities play in interesting role here, especially if they are dollar denominated (which most are). Generally when the US dollar depreciates it makes US products sold abroad cheaper to the residents of those foreign countries. It also makes foreign products more expensive in the US. This generally leads to more exports being sold and fewer imports being bought which - in the US - would generally lower the trade deficit. However oil is a dollar denominated commodity, and since we import a lot of it, our trade deficit is actually going up (see graph from NY Times). Since oil prices are set in a futures market they are a function of expectations of future supply and demand and exchange rates. So questions about future supply and a weak dollar have pushed up oil prices dramatically, something we are seeing filter down to the gas pump. There could also be quite a bit of speculation as well, but it is not yet clear that this is the main culprit. Add to this the fact that food prices are climbing ever higher and that the crop year does not look to be particularly bountiful and you have even more pressure on inflation.

So where does this leave us today? Well, the US is in the midst of a major economic slow-down sparked by the credit crisis. The credit crisis, while still needing a long time to shake out, looks to have been largely tamed by some bold action by the Fed. Now we are faced with some unpleasant realities for the near future. The price of oil is starting to seep into core (non-energy and food) inflation. If wages start to respond (which as of yet they haven't), we could be in for a major inflationary episode. This will cause the dollar to further decline which will mean even higher oil prices. Yikes. So regardless of how the credit market is currently faring, the Fed will almost certainly have to start to raise interest rates. Doing so will quell inflation expectations and drive up demand for dollars which should start leading to an appreciation of the dollar. But it will also cause a slow down in domestic investment at the very time we want more of that to happen. Still the risks are much worse: once wages start adjusting to inflation, the Fed will have to respond much more drastically to keep inflation under control.

So, over the next 12 to 24 months I think we are in for a very tough time. The Fed will almost definitely start to raise interest rates, appreciating the dollar and taking some pressure off commodities prices. This will, unfortunately, curtail credit at the very time we are trying to get credit flowing again which will lengthen the malaise in the housing market. So right now the Fed knows it needs to stay on top of inflation but definitely does not want to jump the gun as the longer they with the more the credit markets can recover before increasing rates. I think we are likely in for a long and painfully slow recovery.

Hold on to your hats...