Good news from down under: The global economy is not as bad as we thought, but the widening difference in interest policies can hurt. In a surprise to financial markets this week, the Reserve Bank of Australia raised interest rates by one-quarter of a percentage point to 3.25 percent. A statement from Australia’s central bank after the announcement noted that more rate increases may be on the way, since Australia’s economy has been relatively strong and demand for its commodities continues to be high.
The U.S. stock market reacted positively with a 1.4 percent increase in the Dow Jones Industrial Average.
In the short term, a declining dollar can benefit U.S. stocks by increasing the profitability of U.S.-based multinational corporations, like McDonald’s and Coca-Cola, and by encouraging investors to move out of low-risk investments like U.S. Treasury bonds and into risky assets like stocks.
According to a New York Times report, investors looked to the dollar for safety during the financial crisis but are now buying stocks, commodities and foreign currencies. “Underlying the dollar’s weakness is the growing perception that many policy makers around the world, and in Washington, may welcome a slow but sustained depreciation of the dollar” the Times reported.
Such a policy, however, is inflationary over the longer term. Dollar priced assets like gold and oil also rose strongly this week as indication of the inflationary trend. Australia’s 3.25 percent and the interest rate in many other countries are well above the U.S. Federal Reserve’s 1 percent rate. U.S. inflationary pressure is rising quickly.
A long-run declining value of our currency is a direct market assessment of relative economic conditions, or economic value. If the drop continues consumers and businesses will quickly see higher costs and slower growth. There is less value here in the U.S.
For investors, a portfolio of global stocks remains the best long-run hedge against these risks. Even though stocks did not produce real, inflation-adjusted returns, over the past decade, no other asset has done better over time.
Over the past century the real return on worldwide stocks was more than 5 percent, while bonds and real estate returned about 2 percent after inflation. Meanwhile, the commodity most often seen as a hedge against inflation, gold, has lost value in real terms.
According to the most recent statements from U.S. Federal Reserve there will be no change to the low interest-rate policy for a long time. The dollar will continue to lose value if others take a different path. In response to increasing worldwide inflation, the question now becomes what other central banks will be raising interest rates. In a Financial Times report, analysts at RBC Capital Markets predict the central banks of Norway, Canada, and New Zealand, will almost certainly be next.
These countries are in a position similar to Australia’s. During this global downturn their banking sectors had fewer difficulties, their economies slowed far less severely, and they continue to export high-demand commodities.
If the Fed and the central banks of Europe and Japan do not raise interest rates like these exporting countries, the price of commodities and other imports in dollar, euro, and yen terms will rise dramatically, lowering our living standards and slowing our economic growth.
The news from down under is good for now, but a long run decline in the dollar will hurt.
b>Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.