US Dollar’s Decline? Think Interest Rates, Not Inflation

Wednesday, October 14, 2009

money-2Many articles are linking the US dollar, gold and oil price moves into a forecast of high inflation to come. Starting with the premise that big government deficits lead to high inflation, those three measures are used as proof that the movement is afoot. There are problems with that analysis…

Let’s start with the premise: deficits produce inflation. I previously explained why that linkage is not currently at work. See Don’t Fear Inflation – Yet.

Now, let’s dispense with gold and oil. They each trade globally, so they are priced in all currencies. Naturally, then, their US dollar prices increase and decrease as the US dollar falls and rises relative to other currencies. Therefore, the fact that they are rising as the US dollar is falling should not be used as additional fodder for the inflation argument.

So, what is driving the US dollar down?

The primary cause of a drop in a currency’s exchange rate is a decline in the relative short-term interest rate (actual and/or expected). There are other demand/supply factors that can affect the exchange rate, but interest rates are the key.

A good example is what happened last week when Australia raised its interest rate from 3% to 3.25%. The value of the US dollar fell from about 1.15 Australian dollars to about 1.10. The reason is that investors, by exchanging from a US dollar short-term investment to an Australian one will see their money grow faster by 0.25% a year. The change in the exchange rate adjusts for that fact.

Now about those other currencies, where the US dollar exchange rate has been falling. The countries haven’t yet increased their interest rates, but the expectations have increased that they will sooner than the US. The basic rationale is that the recent financial and economic problems hit the US worse, so the Fed will need to keep rates low for a longer period of time. This forecast is supported by what the various central banks are saying. Asia will probably see rates rise soon, and Europe appears to be getting ready. Britain, like the US, is lagging. The exchange rates reflect these expectations, as shown here:

Exchange rates

So, don’t worry about the US dollar’s decline. It is just interest rate math at work. And when the Fed starts to raise rates, our turn will come.

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