A Bloomberg.com headline screams Monday: "Dollar Reaches Breaking Point as Banks Shift Reserves." That makes it sound as though the sky is falling, but the real question for U.S. consumers is how will the falling exchange rate of the dollar affects their buying power -- and ultimately, inflation.
"All in all, exchange rates do contain useful information for predicting inflation," noted a September report from the Cleveland Federal Reserve Bank, "but forecasting inflation simply with an exchange rate is a little like eating dinner with only a knife." The report goes on: "Most economists look at a whole slew of data -- from GDP gaps to commodity price trends -- before forming opinions about inflation trends. Exchange rates should be in the mix and used with caution."
Exchange rates do adjust continuously, and if traders believe monetary policy will produce inflation down the road, they will price that into their exchange-rate quotes, the Fed researchers added. Bloomberg.com certainly gives the impression that traders think the dollar is reaching that breaking point, and that inflation may not be far behind.
Central banks around the globe are passing up on dollars to build reserves in euros and yen. That's good and bad for U.S. consumers: A lower dollar means goods cost less outside the U.S., which could spur U.S. exports. If overseas sales of U.S. goods increase, that could mean production at U.S. factories would need to increase and put some people back to work.
But for most consumers, a lower exchange rate for the dollar will mean more expensive imports for U.S. consumers. If the dollar does continue to weaken -- and it's depreciated 40 percent since its 2002 peak, relative to the other major developed countries -- foreign goods like crude oil will become increasingly costly.
Steven Englander, a former Federal Reserve researcher who is now chief U.S. currency strategist at Barclays, told Bloomberg.com that global central banks are getting more serious about diversification and backing away from the dollar. That's no surprise, given that the Bush administration quietly maintained a weak-dollar policy, which the Obama administration has not changed (although President Obama has suggested he wants a strong dollar). You can use this inflation calculator to see the impact inflation has had on the value of a dollar over the years.
As long as U.S. interest rates stay near 0 percent, you won't see many traders flocking to buy U.S. dollars. And as the U.S. tries to finance its growing deficit -- $1.4 trillion in 2009 alone -- foreign governments will increasingly shy away from dollars.
Inflation will eventually hit U.S. consumers very hard, as the Federal Reserve tries to wind down the stimulus. When that happens is anyone's guess, but if the dollar continues to weaken and inflation does hit, your buying power will drop dramatically.
Lita Epstein has written more than 25 books including The Complete Idiot's Guide to Foreign Currency Trading.
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