The dollar's swoon: There's smoke, but where's the fire?
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Since the beginning of this year, the U.S. dollar has weakened by roughly 6.5-7 percent. This swoon follows a burst of strength after last November’s presidential election. Between Nov. 7 and Dec. 28, the Federal Reserve’s broad trade-weighted dollar index rose 4.9 percent.

These are pretty big ups and downs for the dollar. While the exchange rate of the dollar does sometimes fluctuate a lot against a particular currency, the trade weighted index, which considers how the dollar is faring against the currencies of a broad range of our main trading partners, tends to be more stable.

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If the Mexican peso, for example, crashes and loses 50 percent of its value against the dollar, usually the dollar will be fairly stable against the Canadian dollar, euro, yen and other major currencies. In this case, the trade-weighted index might only change a little.

 

One might think that a business-friendly U.S. administration and an advancing recovery would strengthen the dollar. Not this time. During strong recoveries, the Federal Reserve usually has to raise interest rates to keep the economy from overheating. The Fed has raised rates this year, but in measured, 0.25-percent increments.

These increases have made it more attractive for investors to bring money to the United States, but they have not generated enough inflows to the U.S. to strengthen the dollar.

Additionally, it quickly became clear that the new administration would not have an easy time getting new economic policies enacted by Congress. So that factor has turned out to be important, either at least not yet.

The Wall Street Journal reports that there is a pretty broad consensus among investors that the dollar will continue to fall. Investors are betting on the lower dollar with very substantial sums. Swooning is usually not good, but does the dollar swoon put us in real peril?

The answer seems to be probably not, at least at the moment. A weaker dollar helps exporters by making their goods and services cheaper in foreign markets. The largest U.S. companies are now major exporters, too. The weaker dollar has bolstered their foreign sales, profits and stock prices.

One of the usual dangers of a weak dollar would be increased inflation. As the dollar gets weaker, imported goods and services get more expensive, since it takes more dollars to buy that €10 bottle of French wine. However, inflation is so sluggish right now that the weakening dollar has had little-to-no visible effect on U.S. prices.

That could change, but the Fed, which is charged with keeping inflation under control, is still more concerned with bringing inflation up to its 2-percent goal than with keeping inflation from rising.

The weak dollar has created some headaches for other major economies. European firms are seeing some decreases in U.S. sales and profits. This appears to be slowing the tentative but fairly widespread recovery in Europe. Similarly, Japan, which is even more reliant on exports than Europe, has seen economic growth and share prices grow slowly under the influence of a weak dollar.

Slow growth in our major trading partners can reflect back on the U.S. economy, but it is unlikely to cause it to go into recession. But one can construct more dramatic, if less likely, scenarios. If for some reason the dollar did strengthen quickly, large numbers of investors would face losses. This hit to the U.S. financial system could affect the rest of our economy.

Alternatively, fragile commodity-producing economies could go into crisis. To give a historical example, when the Russian government defaulted on bonds in 1998, the U.S. financial system was hit hard. A major hedge fund, Long-Term Capital Management (LTCM) failed, and there were fears about financial crisis.

That situation was resolved by a Fed-organized rescue of LTCM, with fairly little damage to the U.S. economy (but substantial damage to the economies of Russia and many of its neighbors). There is no guarantee that the next shock would be handled smoothly. Many of the institutions involved in betting on the dollar are lightly-regulated financial institutions.

The bad side of this is that no one has a very good picture of the activities or financial condition of many of these institutions. Furthermore, unregulated or lightly-regulated institutions do lots of business with the largest banks, which are central to the stability of our economy. So it is not simple to assess how a surprise dollar strengthening would affect the pillars of our financial system.

An economic or political event could cause investor panic. Think government default in a significant foreign economy, or a military action. Either could lead to substantial flows of money to the U.S., strengthening the dollar. And a sudden strengthening of the dollar would create problems for some sectors of the U.S. economy. But likely the more dangerous issue would be the failure of a major financial institution or disruption in financial markets.

While there are dangers to having a weak dollar, there probably are more dangers in the U.S. economy itself. Economic expansions do not last forever, even with wise economic policies. Even taking the optimistic assumption that Congress will raise the debt ceiling rather than shut down the federal government and that a new budget resolution of some sort will be passed, chances are that something will bring this economic expansion, which started way back in 2009, to an end.

Will it be the dollar that does the expansion in? I am not putting my bet on it, but I would not be shocked either.

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.


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