Expecting the Dollar to Fall Against the Euro

One of the occupational hazards of being a professional economist who writes for a broader audience is that sometimes you lose track of what is and isn’t obvious to smart people who haven’t spent their lives immersed in your field. (Actually, the same problem arises in teaching undergraduates.) So I welcome it when people ask questions in an open-minded spirit, and reveal that there are some points that I’ve been taking for granted as obvious, yet aren’t.

So, here’s a question I was just asked: How can it be that interest rates on government bonds in the United States are so much higher than on European bonds? And not just German bonds – even Spanish and Italian bonds are now paying less than those in the United States. My correspondent wants to know: Is the United States government really a riskier bet than that of Spain?

The answer is no, it isn’t. In fact, investors assign virtually no risk premium to holding American government debt, and rightly so. Even if you thought that the United States might default in the next 10 years, what, exactly, would you propose to hold instead? A world in which America defaults is one in which you might want to invest in guns and survival rations, not German bonds.

So what explains our relatively high interest rates?

Well, let’s compare the situation here with the one in Germany, a country also perceived as almost completely safe – but paying much lower interest. Why?

The crucial point is that German bonds are denominated in euros, while American bonds are denominated in dollars. And what that means in turn is that higher rates in the United States don’t reflect a fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead.

But why should we expect a falling dollar vis-à-vis the euro? One big reason is that European inflation is very low and falling, while the United States seems to be holding near (although below) its 2 percent inflation target.

And other things being equal, higher inflation should translate into a falling currency, just to keep competitiveness unchanged. If you look at the expected inflation implied by yields on inflation-protected bonds relative to ordinary bonds, they seem to imply roughly 1.8 percent inflation in the United States over the next decade, versus half that in the euro area, which means that the inflation differential explains about 60 percent of the interest rate differential.

Beyond that, there is good reason to expect the dollar to fall in real terms over the medium term.

Why?

The relative strength of the American economy has led to a perception that the Federal Reserve Board will raise rates much sooner than the European Central Bank, which makes dollar assets attractive – and as the economist Rudi Dornbusch explained long ago, what that does is cause your currency to rise until people expect it to fall in the future. The dollar is strong right now because the American economy is doing better than the eurozone, but this very strength means that investors expect the dollar to fall in the future.

Finally, Spain and Italy have higher rates than Germany because they really are perceived as risky. But the risk spreads are fairly small these days, so at this point their rates are nonetheless lower than ours.

Now, the interesting point about my correspondent’s confusion is that it ties right into a key policy issue, namely, how much nations like the United States or Britain should worry about bond vigilantes. The answer is: not much, which is apparent once you realize that economic expectations, not fear of default, are the main reasons that rates in these countries go up and down.

It’s too bad that so much of the financial press still doesn’t understand this.