The Dollar Depreciates – And That’s A Good Thing

Interesting to note that the dollar has declined in tandem with economic policy uncertainty, as measured by the Baker, Bloom & Davis index (and predicted by historical correlations).

Source: FRED.

Not all else is held constant. Expected inflation has risen since the election — about 0.8 ppts on the 5 year breakeven — and the real ten year interest rate has fallen: about 15 bps.

That means the decline in the dollar’s value is over-explained. Real rates have fallen somewhat, despite rising expectations of a large fiscal package. Rising expected inflation is consistent with the dollar’s movement, although the increase has been almost 2 ppts since March of 2020.

From my perspective, dollar depreciation is a good thing, regardless of source. A depreciated dollar will encourage expenditure switching to the extent that exchange rate pass through is high (which is higher if from monetary shocks). I think a decrease in economic policy uncertainty is a win regardless — and that seems to have been delivered by the Biden election combined with unified control of the legislative branch.

By the way, the increase in expected five year inflation is a positive insofar as it helps achieve the real rate necessary to equilibrate aggregate demand to aggregate supply (i.e., set the real ex ante rate at the natural rate).

Disclosure: None.

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