Economic Update: The Falling Dollar: Short-Term Gain, Long-Term Pain

It is by now no secret that the U.S. dollar has declined in recent months. In fact during the past two years, the exchangevalue of the dollar has dropped nearly 30% below the last cyclical peak in comparison with the currencies of America's major trading partners. And it is also no secret that many economists and market analysts believe that this recent slide in the greenback will be beneficial to U.S. plastics processors and machinery suppliers in 2004 because it will make U.S.-produced goods and services less expensive abroad, and it will make foreign-made products more expensive in the U.S.

But while the current cyclical downtrend in the dollar's valuation will provide a much-needed boost to our sputtering manufacturing sector in the near-term, there are some negative side effects that will become unpleasant if this slide continues. One problem is that over time, declining currency values push interest rates higher. This is the result of two factors. One is that the inflationary pressures that arise as the result of higher prices for imports. We must never forget that the Federal Reserve Board is ever-diligent against rising inflation, and it will quickly raise interest rates if the rate of inflation accelerates.

Further upward pressure on interest rates is generated because sinking currency values result in decreasing demand for U.S. treasury bonds and other dollar-denominated instruments. And when the price of bonds goes down due to diminishing demand, interest rates go up. So after a while, the stimulative benefits that come from a falling dollar become overwhelmed by the restrictive effects of rising interest rates. It should be noted that the current situation where the U.S. economy is simultaneously enjoying both low interest rates and a declining dollar cannot be sustained over the long-term. Domestic manufacturers, including plastics processors, would be well advised to factor a gradual change in these circumstances into their business planning.

Another, and more immediate, problem facing the plastics industry that results from the declining dollar is the accompanying rise in materials costs. Resins prices correlate closely with the price of petroleum products such as crude oil and natural gas. The U.S. dollar is the currency of choice in the worldwide market for these products. Therefore, when the value of the dollar declines, it erodes the purchasing power of the major oil producing countries and they respond by charging more dollars for their oil.

Two years ago OPEC set the level of $28 per barrel as the upward limit of their targeted price range for oil. But $28 won't buy what it used to in the global marketplace, so this price level has now become the bottom of the target range.

So as far as the plastics industry is concerned, the declining dollar is a mixed blessing. If a processor has access to foreign markets, then he may sell more of his products as exports. But regardless of whether he exports or not, he will certainly pay more for resins as the dollar value goes down.

And one final note concerning the emerging trade issues with Asian countries, most notably China. The American trade situation with China is unaffected by the decline in the U.S. currency because it pegs its currency (the yuan) to the dollar. So when the dollar goes down, the yuan goes down by exactly the same amount. Most economists believe that the yuan is currently undervalued by as much as 25% to 40%. So far, U.S. policymakers have been slow to respond to this problem, and there is currently no announced plan to correct this imbalance any time in the near future.

So to reiterate, domestic processors and machinery suppliers should do everything they can to take advantage of the current situation. Currency valuations and interest rates are cyclical, which means that the trends will eventually be reversed. This is because the present set of circumstances will ultimately generate an imbalance that the market will correct by pushing up either the interest rates or the value of the dollar or both.

The latest forecast calls for a gradual rise in the value of the dollar for most of 2004. Our expectations are that the uptrend will be moderate and orderly, and that U.S. manufacturers will have ample opportunity to adjust to the change. And we strongly believe that there is much more downside risk to this forecast than upside at the present time. This means that the dangers of a continued decline in the value of the dollar far outweigh any problems that will arise from any likely increase this year.

Bill Wood, an independent economist specializing in the plastics industry, heads his own firm, Moutaintop Economics & Research, Inc. in Greenfield, Mass. He may be contacted by e-mail: BillWood@PlasticsEconomics.com