Story Highlights:
• The USD crossed the $1.50 mark versus the Euro, signaling a decline in value
• A negative trade deficit and other factors affect the value of the USD
• Recovery should be focused on lowering the trade deficit
This past week, a significant (if not merely psychological) event occurred. The United States Dollar (USD) crossed the $1.50 mark versus the Euro. The dollar is losing value quickly and this has serious ramifications. Let’s examine why this is happening.
The first place to look is the current monetary policy. A zero interest rate policy was started last December with the federal funds rate (key rate currently at 0.15%). While in the past this rate has been very low, this is the first time rates have reached this level. Due to the dire state of the economy and the credit markets continuing to seize up, more action was taken. The Federal funds rate can be taken below zero by quantitative easing. This is where the Federal Reserve begins expanding its balance sheet. When the market gets flooded by USD, its value is inherently going to decline. Since this policy has been introduced, there has been deflation of the USD of almost 1%. Deflation (which occurs when people are not buying goods) and depreciation of the USD (which causes inflation) are two forces that are working against each other and only one will prevail in the end. At this time, it seems that the United States will end up going through a period of fairly high inflation, especially as other countries, such as Australia, are beginning to raise their key rates. If the United States lags behind, there will be lasting consequences.
The other factor that influences the value of the USD is our current account. The U.S. has had a negative trade deficit for more than 30 consecutive years. A consumer driven economy with a liberal credit policy lies at the root of this problem. In addition, the U.S. government’s budget deficit is causing our national debt to rise to all time highs. A great deal of this cash outflow is from oil purchases. The USD has been the international reserve currency and used to denominate oil and gold in addition to other commodities. China is affecting our currency as well. They have had their currency pegged against the dollar and last year stopped letting it appreciate in value. China is doing this by buying up a great deal of our low yielding treasuries and as a result, holds a significant portion of the U.S.'s debt. This policy is not sustainable for China in the long run either. For the first time, the U.N. recently proposed removing the USD from its status as the reserve currency.
The big question that is on everyone’s mind regards the consequences of the loss in value of the USD versus the Euro. Is this good news or bad news? A better way to answer this question is that the loss is more of a "necessary rebalancing" than anything else. Until recently, there was a major manufacturing component in the U.S economy. As of late, more and more of these manufacturing jobs are being outsourced to foreign countries. For this outsourcing to stop, our currency must lose value to have U.S. goods become cheaper to other nations. The key is to make sure the value stabilizes and simply does not continue on a downward spiral.
Also, energy independence should be looked at carefully. The U.S. economy is, by many measures, driven by oil, which is not sustainable for the long term. There are more reserves that can be utilized, but alternatives need to be addressed. This is an issue in and of itself and could be discussed at greater length. For now, the U.S. must continue to work to reduce the trade deficit through a combination of production of better technical products and a reduction of spending. This combination will allow for a stabilization of the dollar versus the Euro and the world markets.
