Wednesday, April 6, 2011

Dollar update, and related thoughts


At the request of "Adam Smith" and as a public service, here is a chart of the inflation-adjusted, trade-weighted value of the dollar against a broad basket of currencies, with data through the end of February, 2011. (The nominal version of this chart can be seen below.) Today the dollar is essentially at an all-time low against other currencies on both a real and nominal basis, and that marks something of a "misery milestone" if you will. The dollar's extreme weakness reflects a combination of factors: a) the Fed's concerted effort to maximize the dollar liquidity available to the world (in the hopes that this will stimulate the economy and avoid the risk of deflation); and b) the world's weak demand for the dollar, which in turn is likely fueled by concerns related to potentially inflationary monetary policy, massive federal budget deficits, a lack of U.S. leadership, and the relatively tepid U.S. recovery.


The dollar's extreme weakness is a problem in itself, since it automatically reduces the purchasing power (and wealth) of all U.S. residents, and it will exacerbate inflation pressures, since over time most imported goods prices will tend to adjust upwards to compensate for the dollar's weakness. You can't have a weak and falling currency without eventually having rising inflation. Inflation is nothing if not a measure of the loss of purchasing power of a currency.

One other important and related development is that many countries have traditionally viewed their own currencies as being either pegged to, or broadly tracking the dollar; with the dollar in decline, they have attempted through various means (e.g., lower interest rates than they would otherwise have chosen) to "follow the dollar down" in order to avoid having their currencies appreciate vis a vis the dollar and thus rendering their domestic industries uncompetitive (or so goes the thinking—I've never seen a country devalue its way to prosperity). Thus we see that commodities, energy prices, and gold are rising against almost all currencies—although I hasten to add that of late, gold is making new highs mainly against the dollar, and not against most other major currencies. A weakening of all currencies increases the potential for a global rise in inflation in coming years.

I've worried about rising inflation for the past two years or so, but measured inflation so far has been relatively tame. Headline inflation is beginning to pick up, but the Fed argues this is being driven mainly by food, energy, and commodity prices, and central banks should not try to control those naturally-volatile prices. They further argue that the large degree of "slack" in the U.S. economy creates a powerful deflationary effect on the general price level. They focus on "core" prices, in the belief that food and energy prices will eventually track core prices, and the heating-up of inflation that we see in the PPI and the headline CPI will subside with time.

Despite all my concerns, I have noted that to date there is no evidence of any unusual increase in the various measures of the U.S. money supply that might support a significant rise in inflation, and to date there has been no significant decline in the demand for money that might also support a higher and rising price level. Quantitative easing looks and feels very inflationary, but so far nothing much has happened—except for the very weak dollar. Almost all of the Fed's massive injection of bank reserves has been willingly held by a public that apparently still craves the safety and liquidity of those T-bill equivalents. But at the end of the day, the significant decline in the dollar's value is prima facie evidence of an excess supply of dollars relative to the demand for dollars, and that is how inflation gets started.

U.S. monetary and fiscal policy levers have been in max-stimulus mode for quite some time, yet the only obvious result has been a weaker dollar and a struggling economy. This is not surprising to non-Keynesian economists, of course. Supply-side and classical economists know that you can't create growth via the printing press; too much money only reduces confidence and increases speculation, to the detriment of genuine investment. Furthermore, increased government spending only wastes resources that could be put to better use by the private sector, and income redistribution schemes only create perverse incentives (rewarding those who don't work and penalizing those who do).

This leads to the conclusion that we need less "stimulus" if we want to really stimulate the economy. Monetary policy needs to demonstrate a deeply held conviction to preserve the purchasing power of the dollar—to give the value of the dollar precedent over the state of the economy. Bernanke and his fellow Fed governors all profess to believe this, but their actions leave much to be desired. Still, I think it is premature to conclude that the only possible outcome of QE2 is a dollar meltdown, which in turn would lead us to the "end of the world as we know it." There has been no unusual expansion in any of the common measures of the dollar money supply, so any actions that increase the world's demand for dollars could go a long way to fixing the relative over-supply of dollars that is depressing the dollar's value. For example: to quickly boost the demand for dollars, Congress could adopt a new and healthier fiscal policy; and the Fed could embark on a sooner-than-expected tightening of monetary policy. Plus, if the economy continues to improve, as I think it is, this would also boost dollar demand by increasing confidence in the future.

Fiscal policy needs to shrink the size of government by spending less and redistributing less, thereby freeing up resources that can be better utilized by the private sector and creating better incentives to work and invest. Paul Ryan's proposal goes a long way to accomplishing this, and even if Congress does not embrace it I think fiscal policy is now headed in the right direction.

So the weak dollar is a serious problem, but there is no reason yet to abandon all hope.

13 comments:

Benjamin said...

Excellent charts and commentary.

That said, I guess I will never understand why some want an overvalued or "strong" dollar. It is nice when you are a tourist, it is nice if you are trying to acquire overseas assets. A US business wanting re-locate production offshore might argue for a "strong" dollar.

But the trade-enhancing value of the dollar today is providing a huge boost to exports--some say one percent of our GDP growth comes from an uptick in exports. Who doesn't like that?

I sense the dollar has been overvalued for a long time, propped up by its role as a global currency.

The exciting thing will be to watch exports in the years ahead. If we do have a global boom, and the dollar can be kept in a range where it facilitates trade, I suspect we will see a huge surge in exports and US-based jobs.

It takes a few years to make overseas sales. Salesmen have to go the rounds, the paperwork is rotten. I tried once in the 1980s, and it was awful.

That suggests to me the real boom in exports is coming, getting set up now.

I hope we can go to QE3 and keep the dollar in a trade-enhancing range. We are getting closer to lift-off speed in the US economy, but I would like to see Bernanke really pour it on for a few more years.

j said...

Scott,
This question is in regards to your Tues. post 'Equities Are Not Overvalued.' In the WSJ on 3/30/11 on page A17 of my edition, Mark Spitznagel who is chief investment officer of Universa Investments of Santa Monica talks about the 'Q' Ratio which he describes as the aggregate stock market valuation relative to net asset replacement cost.

He maintains that this ratio accurately gauges the market's expectations of returns on tangible capital and resulting profit growth. This ratio has made a half-dozen historic highs since 1900, all of which were followed by much lower stock market prices. This ratio has very recently surpassed all of these highs except for the go-go late 90's.

The 'Q' ratio is new one to me, wondering your thoughts on this? Thx for all your help.
j

TradingStrategyLetter - Weekly Summary said...

Can't get enough of your stuff. Top drawer!

AdamSmith said...

Thanks for the update, Scott. As for the increase in the money supply, from the looks of the chart from the St. Louis Fed on the monetary base:

http://research.stlouisfed.org/publications/usfd/page3.pdf

it looks to be balooning quickly.
As an aside, I very much enjoyed your photos and commentary on Patagonia, I spend a lot of time in AR.

Dr William J McKibbin said...

I agree that the value of the dollar is down -- as a matter of fact, the dollar has lost 96% of its value since the formation of the Federal Reserve in 1913 -- however, I do not agree that it is now my task to make the dollar more valuable for future generations, or even to hold its value where it is today -- rather, I would assume instead that the dollar will lose another 96% of its value during the next 100 years -- with that assumption in mind, how do each of us make money for ourselves pragmatically -- keep in mind that lots of people got rich during the last 100 years even as the dollar lost 96% of its value -- my best advice is to forget about trying to save the dollar and Federalism, and instead focus on positioning yourself to thrive during the coming months, years, and decades -- money loses value, and that's just the way things are -- why is not important -- what is important is figure out how to survive and succeed given the realities around us...

Scott Grannis said...

Adam: the expansion in the monetary base is almost all due to increased bank reserves, which are not really part of the "money supply" that circulates in the economy. For measures of money supply, look at currency, M1, MZM, and M2. They all reflect relatively "normal" growth over the past few years. The expansion of the monetary base could potentially result in a huge expansion of the money supply, but it hasn't happened yet. This is a very important distinction.

Public Library said...

The dollar reflects perfectly the state of America.

1. We are engaged in 3 unpaid foreign wars

2. Our central and state governments are broke

3. Finance, Healthcare, Energy, Utilities, and Defense dominate the corporate landscape

4. The Federal Reserve is engaged in zirp-like policy for the second time in a decade

5. The Federal Reserve is now the largest hedge-fund in the Universe

6. We are monetizing our debt

7. Commodity prices of all sorts are shooting through the roof

8. Wages are stagnant

9. Our economy is driven by 70% consumption on 0-5% savings

10. Our off-balance sheet liabilities make Enron and Lehman look like the once planet Pluto compared to the sun

William said...

"Fiscal policy needs to shrink the size of government by spending less and redistributing less, thereby freeing up resources that can be better utilized by the private sector and creating better incentives to work and invest" .

But US history of the past 13 years suggests that the "private sector" hasn't been superb at utilizing resources: 1998 - 2000 massive over investment in the internet and speculative bubble followed by the 2003 - 2007 massive private sector investment in residential and commercial real estate and that bubble - not to mention the large banks (yes, banks of all institutions) speculating with 25 - 30 times leverage. Something larger is effecting our country.

To me, it appears that not only are our fiscal and monetary policies "out of wack" but also much of the private sector is "out of wack" too - for lack of a better expressions.

I suspect that we have taken our form of freedom, democracy and capitalism to its untenable extreme and no one seems to know how to get them back on track. I am skeptical that simplistic, "tried and true" solutions from either the left or the right will solve these imbalances.

Pogo was right: "We Have Met The Enemy and He Is Us"

Jeff said...

I'm not worried about 'the end of the world', I've read the back of the Book...I know who wins!

But in the mean time, while exporters like Benjamin may like a tanking dollar and Dr McKibbin says just live with it, the rest of us actually are trying to PURCHASE things with what used to be green.

BTW, I think there is a direct negative correlation between the amount of money in a currency and it's value!

Washington wants OUR money. They 1) tax it; 2) borrow it; and 3) deflate it. Make no mistake Benjamin, the falling dollar is a tax on your wallet.

Rome clipped their gold and silver coins. Washington justs prints more (because they can...it's not backed anymore by gold and silver...like the constitution requires).

The end will come. I'm not worried about that. It's what happens in the mean time.

Jeff said...

Right now Washington is arguing (and may shut down the government) over $30 billion. Our deficit this month was $225 billion...$1.6 trillion for the 3rd year in a row!!

The Federal government needs to be cut in half and we are arguing about 1 day of deficits.

Lord help us.

Jeff said...

I meant to say:
"BTW, I think there is a direct negative correlation between the amount of COLOR in a currency and it's value!

Benjamin said...

Jeff-
I just don't believe in doomsterism.

I see extended bull markets ahead, globally, and for decades--like we were having before 2008 meltdown. So what I think is coming is not an exotic scenario. It is the usual scenario.

I do fear financial bombs, ala Long-Term Capital Management, AIG, Lehman Bros, etc.

I am alarmed when I read that LTCM had $5 billion in equity and a $1 trillion in liabilities, They thought they had balanced liabilities to assets. They were Nobel prize winners and had models. The models fell apart.

Aside from financial bombs, all looks good ahead.

Venture capital is abundant, R&D is global. There is a sense the government in Western democracies should not take more than 20-25 percent of GDP, although I would prefer 15 percent.

I do worry about financial bombs, and wonder if any government regulation is needed on this risk, although in general I dislike regulatory solutions.

Scott Grannis said...

Re the "q ratio:" I have never followed this very closely. For one, it seems to look good after the fact, but no one claims it is a good timing device for entering or exiting the market. Two, the denominator of the ratio, presumably the replacement cost of corporate assets, is estimated in rough fashion by government bureaucrats. It doesn't include the value of the labor employed by corporations, or the intangible value of patents and market share.

I prefer some more down to earth stats, especially earnings and profits. I believe the value of stocks is more a function of their underlying earnings, than it is of the cost to rebuild plant and equipment.

The q ratio is certainly something to take into consideration when trying to estimate whether stocks are cheap or not, but it is not the whole story.