1. One simple expectation: a real exchange rate appreciation raises the return to non-traded goods relative to traded goods. The intuition is straight forward: as the currency gains value, prices of manufactured goods (traded goods) fall, while prices of goods and services that do not readily cross borders (houses, for example) do not. Consequently, as a currency appreciates, people ought to invest less in the traded goods sector and more in the non-traded goods sector.
2. Two Simple Graphs:
A. Graph 1 (top) shows the dollar's substantial appreciation in real terms between 1995 and 2003; the dollar remained high relative to the early 1990s until 2005.
B. Graph 2 (bottom) shows the substantial increase in housing prices that began in 1995 and peaked in 2005.
3. One simple hypothesis: The real estate bubble was at least in part a consequence of the dollar's sharp real appreciation between 1995 and 2005.
4. One simple extension of temporal scope: Notice that the 1980s real estate boom also occurred in a strong dollar era.
5. Broader point: the Fed's current dilemma--target the dollar's external value or target the financial system--is merely the continuation of a deeper problem. The low-interest rate policy of the early 00s fed the housing bubble, but higher interest rates at that time would have yielded an even stronger dollar (and hence stronger incentives to shift into non-traded goods). Lower interest rates might have slowed the dollar's rise, but also fueled an investment boom somewhere else. Hence, pick your poison.
The deeper problem, of course is that the Fed has two policy targets (the exchange rate and the domestic economy) and only one policy instrument. The policy appropriate to meet one target is not always appropriate (and can have perverse consequences) for the other.
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