Paul Krugman writes:
Thinking about the dollar: I have to do some teaching on the subject of the falling dollar and whether it’s recessionary. So herewith some ruminations.... [T]hink of the Fed as setting “the” interest rate (more on that later), and facing two tradeoffs. On one side, the lower the interest rate the higher is employment. On the other side, the lower the interest rate the lower the dollar. In normal times the Fed tries to set the interest rate so as to achieve more or less full employment, and lets the dollar fall where it may.
Now along comes a change in investor expectations that makes the dollar weaker at any given interest rate... a weaker dollar means stronger exports and less imports.... We’d expect [this] to lead to a weaker dollar (duh) and also higher interest rates — but the latter effect would happen only because the Fed is trying to offset the expansionary effect of that weaker dollar. It shouldn’t depress the economy at all.
OK, so how do we make this story more pessimistic?
One way is to argue that the Fed will have to raise interest rates more than is necessary to stabilize employment... the falling dollar will be inflationary, so the Fed will have to support the dollar with higher interest rates to ward off this inflation. OK, this could be right, but I have a hard time making the numbers look big enough to get worried about.... Another argument I used to make was that a dollar plunge would pop the housing bubble.... But the bubble popped all on its own....
Finally, there’s a fairly subtle argument about term structure and timing. You see, the Fed only controls short-term interest rates, while investment spending depends on long-term rates. Meanwhile, the effects of a weak dollar on exports take a while, maybe as much as two years, to take full effect.... This story depends on the effect of interest rates on demand working faster than the effect of the exchange rate on exports. I guess this could work. But it’s a fairly tricky story, and a lot subtler than the alarm I’ve been hearing....
When people wonder why anyone would invest in the US without a rise in interest rates, you have to make the distinction between a falling dollar and a fallen dollar. If the dollar gets really weak, investors will see US assets as a bargain.... The question is how far the dollar has to fall to make that happen, and whether the Fed can let that big a fall happen.