Gold Bugs, Exchange Rates, and Monetary Policy

Beware the dollar hawks says Krugman in a recent post to his blog. The dollar is depreciating quickly and many (Krugman’s many I have not fact checked) are calling for somebody to do something about it. Krugman believes there is a danger in this call. And for once, I am in unambiguous agreement with him.

Using monetary policy to control the value of the dollar would be a policy mistake.

The Fed is already trying to do too much with a single policy tool. Adding yet another criterion to their already long list is too likely to lead to policy mistakes. The Fed needs to keep its eyes on the balls already in the air and not add balls to impress like a foolish street juggler.

But, at the same time, the Fed should not disregard the exchange rate as a signal of overly loose policy. The exchange rate is perhaps the best, broadest, and most flexible dollar denominated price. A depreciation of the dollar is inflation—the dollar price of foreign goods goes up. It reflects the average relative price of dollar goods. Amongst their other price signals, the Fed should monitor the exchange rate. The value of this mechanism as a price signal ultimately lies behind the current dispute amongst various members of the FOMC, no different than the debate 4 years ago on the value of the Cleveland Fed’s median inflation rate.

The danger of the Fed ignoring these signals is exceptionally high at the moment. There is a group of economists (Roubini talks about this all the time.) that have been looking for a decline in the real value of the dollar for a long time. They view the real value of the dollar as an equilibrating mechanism to adjust the pattern of global demand. If the Fed shares these beliefs, they may confuse a nominal movement in the dollar with the long-looked-for real depreciation.

Remember, any price has two components, real and nominal. The real component reflects an equilibrium between supply and demand (of and for the good). The nominal value reflects and equilibrium between the good and money. The Fed controls the latter (to an extent) and never the former.

To tie it all together, the Fed should be careful not to confuse the real and nominal value of the dollar. From their perspective, unexplained movements in the dollar are probably nominal.

Watch the value of the dollar but don’t target it.