Who’s Afraid for the Dollar? Part III- Can the Dollar Weaken Anyway?

The first two parts of this series dealt with the reasons the dollar is not about to collapse, but could the dollar weaken anyway? The short answer is a resounding ‘yes’. The dollar’s value will fluctuate and it may even decline fairly significantly in value as a result of all the recent monetary policy. However, hyperinflation is not in the cards, nor is an outright dollar crisis.

Take a look at the Real Trade Weighted Dollar index. This index maintained by the Fed weights the various exchange rates by the amount of trade conducted in each country. Thus, it is a good representation of the supply and demand for dollars as priced in a basket of currencies. I am specifically choosing the real index as opposed to the nominal index because when inflation various between countries, the effect on the index can be one of massive distortion. Fortunately the Fed has made the appropriate adjustments in the real index presented below. (If you’d like to see the nominal index, you can here. It can either be interpreted as a massive bubble in the dollar popping or as a fairly meaningless chart. I submit it is the latter because the value of the dollar actually fell quite a bit when Nixon closed the gold window ending the Brenton Woods paradigm of fixing the dollar to gold. That devaluation is not reflected in the nominal index at all).

As you can see from the chart above, the dollar has recently gone through two mini-bubbles. The first was in the 1980s. As then Fed chair Volcker raised rates and broke the inflationary spiral, real interest rates remained unusually high (a “real” rate is the interest rate in excess of inflation). High real rates make a currency attractive and the dollar entered a bit of a boom.

Beginning in the early 1990’s, the dollar entered its second mini-bubble. As American conspicuous consumption ramped up along with the tech bubble and demand for US tech stocks, the dollar gained considerable strength. At the time, it wasn’t viewed as an overvaluation in part because Clinton’s Treasury Secretary, Robert Rubin, proclaimed a “strong dollar policy” as desirable while China and Japan began keeping the dollar artificially strong in earnest.

It is the slide down from that height that appears so dramatic. However, as you can plainly see from the chart, the current value is not in any way new territory. The dollar has been here before, for considerable stretches of time, without unraveling the world.

Consider that when the dollar weakens, it forces other countries to stop depending so much on the American consumer buying their exports. A more balanced, healthier and growing global economy should result. A weak dollar is part of the solution and it is being reflected accordingly.

How low can it go? That’s hard to say. It could certainly get weaker, particularly since the nominal exchange rate value is still quite high. And it may stay down for some time. The major adjustment so far has been against the Euro, when the bulk of our trade deficit is with Asia, which leads me to believe the index won’t bottom until China (and other significant Asian exporters) allows the currency to trade more freely, something Chinese leaders are loathe to do.

Another very bad outcome for the dollar may happen if Congress starts dismantling the Fed’s independence and/or doesn’t reign in long-term deficit spending. (The Fed is technically independent of both the President and Congress; a few years of large deficits are ok, but watch out if Congress can’t get control of it). Be wary of any politician that thinks the Fed is the problem.

However, an Icelandic experience (the country went bankrupt and even McDonalds closed their stores there) or Weimar Republic style inflation is so unlikely that I’d call it nuts. (Don’t hold me to that in 50 or 100 years though, I’m talking about in the next decade).