The weakening of the U.S. dollar on foreign exchange markets Tuesday created more pressure on policy-makers in Washington to defend the dollar by raising interest rates at the risk of triggering a domestic recession.
The dollar reached record lows against the West German mark and the Japanese yen in early trading Tuesday before rebounding slightly in profit taking. At the end of the day, the dollar stood at 1.7173 marks and 137.50 yen, up a fraction from Monday but 46% below its 1985 peak.
Currency traders said the absence of a definitive statement by the U.S. government on cutting the federal deficit and the lack of a sense of where interest rates are headed contributed to the skid.
Economists viewed the continued instability of the dollar, which has declined dramatically since the stock market crash last month, as another sign of the evaporation of confidence in financial markets.
The trouble is that efforts by the Federal Reserve to restore confidence in the dollar by raising interest rates is precisely the opposite signal required to rebuild optimism in the stock market.
"The domestic market is looking for the Fed to pump in liquidity by lowering interest rates," said Stephen Marris, who specializes in currency analysis at the Institute for International Economics, a research center in Washington. "Foreign markets are looking for a signal that the Fed is prepared to let interest rates rise and defend the dollar."
The dollar's decline reflects the fact that foreign investors are no longer willing to finance the U.S. spending deficit, economists said. Higher interest rates would be required to keep foreign investors in the U.S. markets.
Lower Living Standards
The dilemma confronting the Federal Reserve is that if interest rates are pushed too high, a 1930s-type recession could follow the recent stock market crash. On the other hand, allowing rates to go too low could fuel inflation and lead to further fears among investors.
A weak dollar helps narrow the trade deficit by giving U.S. firms a price advantage abroad, but it also increases domestic inflation by increasing the cost of imported goods and decreasing competition for domestic producers, which allows them to raise their prices, said Dale W. Larson, a senior economist at Bank of America in San Francisco.
"It means that our living standards are lower because we can't have all the relatively inexpensive imports that we have been enjoying in recent years, and we also would expect to see the price of competing domestic goods go up," Larson said.
In other words, the cost of a new Toyota or BMW will go up, but so will that of a comparable American car.
Marris, who testified before Congress last Friday about the potential risks from the declining dollar, said in a telephone interview that the Fed will have to send a signal on interest rates to the world financial markets in the next few days or risk seeing the dollar go into the sort of free fall that marked the collapse of the stock market Oct. 19.
"Clearly the center of action has moved into the foreign exchange markets from the stock markets," Marris said.
Other economists see a need for action--possibly a major move by Congress and the Reagan Administration toward reducing the federal deficit--but believe that there is more time to respond.
Lars J. Pedersen, a senior economist at Merrill Lynch & Co. in New York, said the dollar might stabilize and provide policy-makers with enough time to restore the confidence of foreign investors by unveiling decisive action to reduce the federal deficit.
"I'm assuming there is a good chance we can still do it, but I'm not saying that it's guaranteed," Pedersen said.
The dollar peaked in February, 1985, at 3.47 marks and 260 yen and then went into a fairly steady decline. The fall was stopped last February, when the finance chiefs of the seven big Western industrial powers met in Paris and signed the so-called Louvre agreement.
The pact signaled the cooperation of the central banks of each country, including the United States, to try to hold exchange rates within a certain undisclosed target range by adjusting domestic interest rates and intervening to buy currency when necessary.
The strategy worked fairly well until the worldwide stock market crash changed economic factors so dramatically that the currencies were driven out of the agreed-upon range.
Pedersen and Larson said the dollar may simply be finding a new range in response to the stock market turbulence. But Marris expressed concern that failure to take decisive action on reducing the federal deficit could send the dollar spiraling downward out of control.
Meanwhile, gold prices fell, the Associated Press reported. Republic National Bank in New York reported a late bid of $467.50 an ounce, down from $469.80 Monday. The metal closed at $468.40 on the New York Commodity Exchange, down from $470.10.
Dealers overseas told AP that gold prices fell sharply amid reports that the Bank of Japan sold bullion to finance its interventions on foreign exchange markets in support of the dollar.
In London, gold fell to a late bid of $465.50 an ounce, down from $470 late Monday. It dipped to $464.50 bid from $470 in Zurich and eased to a closing bid of $470.39 from $470.68 in Hong Kong.
Silver finished at $6.820 an ounce on the Comex, down from $6.925 Monday. In London, silver fell to a new six-month low of $6.76 bid from $6.99 late Monday.