A lot of debate has taken place about what determines the relative value of a currency. To most, a nation’s trade balance, budget deficit, and relative economic status are the major determiners. Nevertheless, supply and demand remain the major factors that shape the relative value of a currency.
The weak dollar is not necessarily a sign of fundamental weakness in the nation’s economy. The U.S. has undergone several cycles of the weak and strong dollar, and never have these cycles made the economy better or worse.
Are the Authorities Ignoring the Slide in the Dollar’s Price?
The declining dollar to some extent creates inflationary pressure as imports become costlier. In a situation like this, if the Federal Reserve Board continues to cut rates, it is more likely to provoke inflation. It can also bring in a dangerous combination of weak growth and high prices.
In the last several years, the country has witnessed dramatic economic imbalances. The only effective way to correct these imbalances is to increase the country’s savings. However, the administration has not dared to take this measure, as it would require rolling back excessive tax cuts and government-led health care reforms.
Instead, the administration has opted for a quicker fix — letting the dollar fall. The weaker dollar makes U.S. exports more affordable, narrowing the trade deficit and helping the nation to ease imbalances.
Although the administration has not shied away from taking credit for the five percent decline in the trade deficit in the year that ended in January, the improvement is more a result of the growth in exports made possible by the fall in the dollar’s price.
How Deep Will the Dollar Plunge?
With the drop in the dollar’s value, many investors have diversified their portfolios by including other currencies. This trend results, however, in the further decline of the dollar. Some Middle Eastern countries have also hinted that the future pricing of oil may not entirely be in dollars. If that happens, it would cause further downward pressure on the dollar’s value.
What’s more, if the Fed continues to slash interest rates to rectify the American economy, investors may move their money to securities in other currencies to fetch better returns.
Since 2002, the dollar has steadily lost ground to the euro and other major global currencies. The perception is that the slide may continue for a long time with China and other Asian nations pumping out exports to the U.S. and buying dollars to contain the prices of their own currencies. Moreover, many oil-rich countries are seriously considering alternatives to the dollar. Any such monetary policy adopted by the Persian Gulf nations could further dampen the dollar’s value.
While most observers believe the dollar will rise again, no one is able to predict when it will happen.
