Sunday, November 14, 2010

U.S. dollar once again at an all-time low

This chart is arguably the best measure of the dollar's value relative to other currencies. It compares the dollar to a large basket of trade-weighted currencies, and it is adjusted for relative inflation differentials. This eliminates the distortions which come from, for example, a large nominal rise in the dollar against a currency that is suffering from very high inflation: if the dollar's rise offsets the effects of that currency's inflation, then the dollar has not really risen at all. Similarly, it corrects for large depreciations of the dollar relative to currencies (in particular the yen) that have enjoyed lower rates of inflation than the U.S.

The latest data from the Fed show that the dollar has once again—for the fourth time since the early 1970s—hit bottom. It is now as effectively weak as it was in Oct. '78, Jul. '95, and Apr. '08. Put another way, a U.S. tourist traveling around the globe today would find that his dollar has never bought less. For that matter, a dollar today has never bought less gold, fewer industrial commodities, or a smaller basket of consumer goods and services.

To say that the U.S. economy is at risk of deflation, at a time when the dollar has never been weaker, is nothing short of cognitive dissonance. One wonders what, exactly, the Fed is looking at when they reason that a bold, risky, and unprecedented experiment in monetary expansion (i.e., QE2) is justified. When the dollar's value is at an all-time low, it follows that there has never been such an oversupply of dollars relative to the world's demand for dollars as there is today. There are more than enough dollars flooding the world already; we don't need even more.

The market is smart enough to figure this out, of course, and that is undoubtedly one of the reasons the dollar is so weak today. Given the prospect of more dollars being dumped into the system tomorrow, the market's demand for dollars has already declined, depressing its price. So the real key to the impact of QE2 will be how it compares to what the market has already priced in. It remains my belief that the reality of QE2 will prove to be less than the anticipation. The Fed will not remain oblivious to the monetary realities forever, and the U.S. economy is already stirring in anticipation of a positive course correction in fiscal policy.

We have survived similarly weak episodes in the dollar before without a devastating rise in inflation (with the notable exception of the late 1970s, when inflation rose to the low double-digits following the dollar's plunge in 1978), and there is no a priori reason we can't do it again.


Benjamin Cole said...

Perhaps all that the able Scott Grannis has said is true; on the other hand, the Department of Labor on 11/4 reported unit labor costs are in fact deflating, down by 1.8 percent in the third quarter y-o-y.

Commercial rents of all kinds are in fact deflating, retail, warehouse and office. My rough-house guess is that means 70-80 percent of business costs are deflating, while aggregate demand is weak. That is in fact a recipe for deflation.

Deflation is worth avoiding.

Tenacious deflation has been Japan for 20 years, recently topped off lately by 18 straight months of deflation.

Property and equity values are off by 75 percent or more in Japan in the last 20 years. The Nikkei Dow crossed over 40,000 in 1990; today it is under 10,000.

That can be America's future too.

Ben Bernank, a Republican appointee, strikes me as the very picture of sobriety, caution, circumspection and intellect. Perhaps too much so; he has been slow to go to QE.

But he has made the right choice, despite some criticism. Add steadiness to Bernanke's qualities. I think we are deeply fortunate that a fellow who studied the Great Depression and Japan happened to be Fed Chief at the time of the Great Bush jr. Econo-Poisoning.

Fixing our economy will take time, and Obama is perhaps off-course.

But Bernanke is putting in the endzone.

seekingtraceevidence said...

The Yen has risen vs. US$ fallen due to HFs moving the carry tradt to US$ to capture QEII effects. I am not convinced that there is any more to it.

Public Library said...

I read a great article about the 70's inflation. Apparently Richard Nixon pressured Arthur Burns (tapes now public) to print dollars ahead of his re-election effort. Burns was more than obliged to do so because he was a conservative Republican. You can see the effects in the M2 leading up to the election.

Back then most people focused on M1, including Nixon, and this figure did not show as much juice as he would have liked. However, M2 was in the high single/low double digit growth trajectory. Nixon pressed for more monetary juice anyway and got it. The rest was history of course.

Nixon was a paranoid politician but it goes to show the Federal Reserve is not really independent in case anyone has doubts.

Scott, you are now simply hoping for hopes sake against a backdrop of abysmal Federal Reserve policy making going back 30+ years.

On the margin, everything points towards inflation even though we cannot see it fully reflected in the official figures. Now is not really the time to ignore your own philosophy about the margins.

Scott Grannis said...

There were many factors contributing to the outbreak of inflation in the 1970s, beginning with the Fed failing to follow the dictates of the gold standard in the mid-1960s. By the time Nixon beat up on Burns, the economy had already experienced easy money for over 5 years. Then confidence in the dollar was destroyed when Nixon decided to go off the gold standard. A collapsing dollar (an unprecedented collapse) coupled with easy money added up to a truly inflationary mix. Things are not nearly so bad today.