One thing that worries me about the US economy

Although the high levels of public and private debt in the US should concern me, and the collapse in asset values should have me shaking in my boots, there is another factor that has me really concerned about the outlook of the US economy: The exchange rate.

Now, the US$ is still weak relative to history, sure, but that isn’t my issue. My concern is the way the US$ moves in the face of new information about the US economy.

Traditionally, when good data comes out a nations dollar appreciates. This is a good thing as it weakens inflationary pressures (by knocking down tradable goods prices) but it also moderates the size of the upswing in economic growth, by lowering export volumes and increasing import volumes. So when an economy is growing past trend, this helps to slow it.

When bad data comes out the dollar will depreciate. In a situation where the economy is growing below trend there is downward pressure on prices anyway, so the increase in tradable inflation shouldn’t matter (beware the supply shocks though!). Furthermore, the higher price for exports and imports leads to higher export volumes and lower import volumes – helping to prop up flagging growth.

As a result, the exchange rate provides additional economic stabilisation!

However, in the US it appears that bad economic news is leading to an appreciation in the US dollar, while good economic news is causing a depreciation. This implies that exchange rate changes are actually adding to variability in the US economy.

The reason for this appears to be the linkage between the domestic US economy and the rest of the world. Traders have the feeling that if US consumers are busily buying, this will prop up the rest of the world, which puts traders in a position where they are comfortable buying high yielding foreign currencies. However, if they think the US will tank currency traders want to shift their money from the high risk/high yield currencies to “safer bets” – such as the US dollar.

Now the tradable sector of the US economy isn’t too big relative to the rest of its economy – however, its big enough to cause undue variability in the economy.