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U.S. Dollar Keeps Falling

Bhuwan Thapaliya - 8/3/2007

An economist, it has been said, is an expert who will know tomorrow why the things he predicted yesterday did not happen today. This is especially true of currency forecasting too. Over the past couple of years economists have repeatedly forecast that the dollar would strengthen against the other main currencies. They have been wrong.

Euro has risen to new highs against the dollar, and the pound also extended its gains against the dollar by hitting a 26- year high against the US currency. The result has put the dollar under some sustained pressure. And analysts fear that the dollar is all set to sink further because the investors are fearful of the US housing slump.

On the other hand, both the euro and the sterling have benefited from recent interest rates rises by the European Central Bank (ECB) and the Bank of England. While the ECB has kept eurozone rates on hold at 4% on July, they have doubled in 18 months, and more rises are expected by the end of the year, according to the reports.

“The Bank of England last week increased rates to 5.75%, and most analysts expect a further rise before the end of the year, as both it and the ECB move to slow inflation. In contrast, US rates were kept on hold at 5.25% following the Federal Reserve's most recent rate-setting meeting last month,” according to the report published by the BBC.

The dollar’s latest dive has been blamed, among other things, on America ’s widening trade deficit, soaring oil prices, its lackluster war performance in Iraq and the weakness of the American Central Bank in raising the interest rates. These are all plausible explanations of the dollars temporary sickness. Nonetheless, most economists continue to expect it to revive. But that expectation ignores a growing gap between the dollar’s importance to the world economy and America ’s economic weight.

The dollar still accounts for more than 50% of foreign exchange reserves and roughly half of global private financial wealth; two- thirds of world trade is invoiced in dollars. So it is more than just possible that investor’s appetites for dollar assets may shrink further.

As ever the economics profession has minted many explanations for this “puzzling” weakness. Perhaps, the real puzzle is not why the dollar is being shunned, but why it stays so popular. After all, the dollar no longer fulfils the classic function of an international reserve currency. It is no longer a reliable store of wealth.

Since 2000 it has lost its value against the D- mark, yen, Euro and the Pound Sterling. Traditionally, the issuer of the main currency has been a net international creditor, giving it a keen interest in low inflation and financial stability. America was the world’s biggest creditor until the 1980s. But it is now the world’s biggest debtor and so unlikelier to succumb to the temptation to let inflation nibble away at the real value of its debt, or to devalue in order to narrow its trade deficit.

A bit of fuss in America ’s housing market has distracted attention from the behavior of the country’s currency. This has been perplexing for many economic forecasters, who were convinced that dollars would rise for most of this year. Instead, it barely moved up but sank further down. No one knows when it will take off.

But some analyst reckons that it will take off for sure. So investors need not worry that much because the dollar’s lackluster performance is not likely to last for long. It will bounce back.

The latest fillip for the dollar was the news that the United States had created more jobs than expected. This sign of buoyant economy has led many to conclude that the next move in American interest rate will be up, not down. While the prospect of higher rates might spook the bond and equity markets, it will boost the dollar, which has sunk to a 26 year low, against the pound sterling.

But even if the dollar floats upward, there is strong change, in the long run, that it will drift back down again. For one thing, America ’s average inflation rate is likely to remain higher.

Meanwhile, if America is to raise the value of its dollar, then it must shrink its current account imbalances. Fed’s monetary policy should also help whisk the dollar upwards. With America ’s economy growing more strongly, its interest rates are more likely to rise this year.

Another problem for the dollar is that central banks, especially those in Asia , are likely to continue to diversify their dollar reserves into other currencies in coming years. Last, but by no means least, countries that run chronic current account deficits tend to have undervalued currencies. America has a structural current account deficit, so the dollar is therefore unlikely to climb much higher without a big fall in America ’s current account deficit.