The dollar fell sharply enough in the first three weeks of January to make the headlines.

Although this depreciation is a continuation of a movement that has been going on for almost two years, the steepness of the recent fall raises a number of questions. Why did the dollar depreciation speed up of late? Will interest rates rise as investors abroad hold back on acquiring dollar assets? Is the dollar headed for a free fall?After depreciating irregularly from a peak in February 1985, the average value of the dollar stabilized in the summer of 1986. From August to mid- December, the Federal Reserve measure of the trade-weighted value of the

dollar was unchanged, as the dollar depreciated further against the West German mark but appreciated in terms of the Japanese yen.

From mid-December to Jan. 19, the value of the dollar fell by about 10 percent against the mark and 7.5 percent against the yen.

Some of this depreciation has been attributed to open-mouth policy - statements made by anonymous Treasury officials and outright support for the

dollar decline by identified members of Congress. Yet, there are perfectly sound economic reasons why the market should have renewed the depreciation on its own.

One reason is that the U.S. trade statistics for November, announced Dec. 31, showed a large jump in the monthly trade deficit, to $19 billion. Whatever this preliminary figure is worth, it had an effect on the market's perception of the trade problem. The deficit suddenly looked larger and more intractable than earlier. The reduction in the trade deficit that the dollar depreciation was supposed to bring about seemed further away. It is not surprising that the foreign exchange markets reacted by marking down the dollar.

Another reason for the weakness of the dollar is that the year-end is the season for economic forecasts and many of these predict a sluggish U.S. economy this year, especially in the first half. In fact the main expansionary force in many forecasts is the expected decline in the trade deficit. With that less likely, the outlook is for falling interest rates and possibly an easing of Federal Reserve policy. In these conditions, the dollar was likely to depreciate.

Still another reason for the decline of the dollar is that the West German-French disagreement over exchange rates in the European Monetary System was resolved by a revaluation of the mark rather than by a reduction in West German interest rates. This told the market something about the trade-offs of West German policy-makers. West Germany's interest rates are not likely to be reduced and the authorities there are not too averse to appreciation of the mark. The market promptly obliged by pushing the mark up further against the


Is the sharp fall of the dollar likely to bring on higher interest rates in the United States as investors abroad are discouraged from buying assets denominated in dollars? While nothing is sure in this world, it is noteworthy that the dollar has depreciated since early 1985 while U.S. interest rates have fallen rather than risen. The major explanation is that the dollar depreciation did not engender expectations of future depreciation. During most of the period of depreciation, market participants were never sure that the

dollar would fall further.

It is important to distinguish between actual and expected depreciation. If investors abroad confidently expected the dollar to go down, it would make sense for them to delay their acquisitions of dollar assets. But once the depreciation has occurred, dollar assets become more attractive, since their price has fallen in terms of other currencies.

The relevant question therefore is: Do investors widely expect the dollar to continue to depreciate? The fact that the dollar has not fallen each day but has gone down intermittently points to uncertain expectations. This suggests that U.S. interest rates are unlikely to rise significantly. And they have not yet risen during the recent period of rapid depreciation.

The same considerations tell us something about the likelihood of a free fall of the dollar. A free fall would be a speculative movement that fed on itself based on strong expectations of continued dollar depreciation. The possibility of a free fall usually is associated with the possibility that investors abroad, on whom the United States is dependent for the financing of the current account deficit, will lose confidence and withhold purchases of U.S. securities and other U.S. assets.

No one can deny that this could happen. But such withholding of

investments is likely to be a temporary phenomenon. Where else are those investors going to put their funds?

As long as investors abroad have confidence in U.S. monetary policy, they are not likely to hold off for long. This implies that the recent gossip about Paul Volcker's successor may have been another influence on foreign exchange markets and could continue to be.

This subject does not lend itself to unequivocal conclusions. What can be said is that the additional dollar depreciation we have experienced in the past month, whatever concerns it may have raised about future financial stability, is a step in the right direction. Most economists would agree that the extent of the depreciation even now is probably not enough to put the U.S. trade deficit back in balance. That does not mean that the additional decline of the dollar has to come all at once. The present degree of depreciation is enough to turn the trade balance around and start it down.

But the dollar has not yet overshot the mark - or the yen.

For the full story: Log In, Register for Free or Subscribe