Dollar update: inflation forces are brewing

The dollar is struggling. It hasn't suffered a knockout punch, but it is definitely weak and appears to be in a declining trend. These charts are two different ways of looking at the value of the dollar. The first is arguably the best way to measure the dollar's value relative to the currencies of all our trading partners (it's trade-weighted and inflation-adjusted). It's telling us that the dollar today is only about 6% above its all-time lows. The second chart measures the dollar's strength against gold, and it is telling us that the dollar is within inches of all-time lows (gold being inches from its all-time dollar highs). Gold has in fact gained against all currencies in the past few years.

As a supply-sider, I believe that strong currencies are always better than weak currencies. As a next-best alternative, I'll take a stable currency. Currency stability means that over time purchasing power will be stable. Stable purchasing power does wonders for one's investment perspective, since it eliminates an important source of risk (i.e., inflation) to investment. Stable and strong currencies thus tend to be magnets for the world's capital because they offer lower hurdle rates to investment. Those countries that attract capital tend to have strong economies and relatively high living standards, thanks to strong investment.

As my previous post indicated, a weaker dollar has enhanced the returns to overseas investing. All of the world's equities markets are rising, but when measured in dollars, the U.S. market is a laggard and foreign markets are the frontrunners (e.g., the Brazilian stock market is up 140% from its November lows when measured in dollars). In my way of seeing things, a weak dollar acts like a headwind to recovery, since it reduces the amount of investment capital we might otherwise receive from the world. Obama's big-government spending and tax increases won't kill our economy, and neither will a weaker dollar, but they do amount to serious headwinds that will significantly increase the amount of time necessary for the U.S. economy to recover its previous potential.

The dollar enjoyed a brief period of strength in the latter half of 2008 (through mid-November), thanks mainly to a global flight to quality. Being the world's reserve currency meant that the dollar was the safest port in what proved to be a Perfect Storm. The demand for dollars exceeded the Fed's willingness to supply dollars late last year, and so the dollar's value rose against most other currencies and rose against gold as well.

Now things are reversing. Global demand for dollars is declining as the prospects for the global economy improve. Meanwhile, the Fed remains extremely accommodative, willing to supply an almost unlimited amount of dollars. Loan demand has not been very strong, however, so the vast majority of the reserves the Fed has pumped into the system remain idle. Instead of borrowing more, it seems that an awful lot of people and firms are still trying to deleverage. But as the recovery progresses and confidence returns, the demand for dollars is likely to fall relative to the Fed's willingness to supply dollars (and loan demand is likely to pick up), and that will erode the dollar's value, at least in terms of gold if not vis a vis other currencies. A weaker dollar will be a key indicator of an excess of dollars, and that is the essential ingredient for rising inflation. Ultimately, a weaker dollar increases inflationary pressures, regardless of how weak or below-trend the economy is.

Measured against gold, all of the world's currencies are in trouble, with the possible exception of the yen, which has only dropped 13% against gold in the past two years. Like many others, I believe that gold is a good way to measure the value of a currency in absolute terms, since gold has done a good job of maintaining its purchasing power over long periods, and countries who have pegged their currencies to gold have invariably experienced very little or no inflation. It would appear that all the world's major central banks are following the Fed's lead, aggressively supplying bank reserves in an effort to avoid a banking crisis. That's fine for the moment, but the price we're likely to pay will be higher inflation all over the world in the years to come, particularly if central banks are slow to withdraw their liquidity injections.

Given the trends so far this year, I think prudent investors need to be prepared for rising inflation in coming years and for sub-par U.S. growth (i.e., 3-4% growth, instead of the 6-8% that we would expect if this were a headwind-free recovery). TIPS are a conservative way to protect money from inflation, since they are adjusted directly for inflation and they pay a coupon (i.e., real interest rate) to boot. Gold and commodities are more aggressive, and much more risky, ways to protect against inflation, since a) they pay no interest rate, and b) they are well above their recent lows and their potential gains or losses are significant. Emerging market economies should continue to do better than industrialized countries, since they benefit from a weaker dollar and rising commodity prices, and many of them (e.g., Brazil, Chile, China, Peru, Singapore, Thailand) have managed to keep their currencies quite strong relative to the dollar in recent years. Equities in general should do well, since markets are still braced for recession and fear continues to distort investment decisions. The things to avoid like the plague are the "risk-free" investments such as T-bills, T-notes, and T-bonds.