Sinking Dollar: This Time on Purpose

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The Fed wants to keep the inflation rate up around 2%, simply because their efforts to boost the economy only get traction when they can push interest rates well below the inflation rate — something that's tough to do when the inflation rate is as low as it's been.

Normally, it's no problem to produce inflation: The Fed just creates some additional bank reserves. The banks respond by lending more money to businesses and consumers — who spend the money. That extra money out in the economy buying stuff is inflation. Rising prices follow directly (unless production is growing even faster than the money supply).

Just lately, though, the Fed has been stuck. A lot of businesses and consumers can't borrow, because they can barely service their existing debt. The ones who could borrow don't want to. And many banks have a balance sheet that's too shaky to support much lending, even if they can find a customer who's both willing to borrow and able to pay the debt back. The extra bank reserves just sit there.

But it's looking like the Fed has found a channel to produce the effect it wants: the exchange rate.

You can see in the graph above the two recent dollar lows — one in the early days of the recession and then another in the early days of the recovery. Just lately the dollar has been plummeting again. That's inflation too. In fact it is the very definition of inflation, which is the money becoming less valuable. (Rising prices are merely the symptom.)

Weakening the Dollar

Normally, the Fed (and the Treasury) like a strong dollar. It's good for consumers — a strong dollar means that imports are cheap. It's also good for most businesses. Exporters don't like it, because a strong dollar makes their goods less competitive overseas. But because the US imports so much of its fuel, a strong dollar is a win even for many businesses that export a lot of what they produce.

At the moment, though, the stars have aligned such that there's a lot of support for a lower dollar. That gives the Fed the opportunity to produce the inflation it wants — by weakening the dollar overseas.

Fed officials have been talking about "additional accommodation" and "further purchases of longer-term Treasury securities" for some time, and the minutes of the most recent Fed meeting show that they've been thinking about it for weeks. Judging from the hints so far, it looks like the Fed is going to buy a few hundred billion dollars of longer-term Treasury securities over the next few months. That will produce some inflation in the usual way (even though, as described above, that channel is mostly blocked). It will also push down longer-term rates, which has the knock-on effect of making the dollar less attractive to investors who want to hold bonds. That may make a few businesses and consumers a little more able and willing to borrow and spend. It also makes it less attractive for foreign holders of bonds to hold bonds in US dollars. (That's why the dollar has been dropping so fast just lately.)

And it's that falling dollar that's the real channel for this effort to have its effect. A less-valuable dollar is exactly what the Fed is trying to produce. That will lead to rising prices (initially for imports, but very soon for everything). Normally, its most immediate effect — rising prices for oil and other commodities — would make any effort to push down the dollar too unpopular to consider. But, just at the moment, there's something of a political consensus that we need to to push the dollar down. (Mainly, there's a general sense that we need to push the dollar down against the Chinese yuan, but that's very hard to do directly. However, it's very easy to push the dollar down in general. Then it will be somebody else's problem to get the details right as far as relative changes versus the yen and the euro and the Canadian dollar.)

What it Means, What to Do

It's pretty tough for Americans to protect themselves against a falling dollar.

Shifting some of your savings into some foreign currency is an option, but that's fraught for several reasons.

1. It negates the one big advantage of holding cash, which is that you can always use it to pay your bills. (I know exactly how many dollars I need to pay my rent from now until my lease runs out. I can only guess how many euros I'd need.)
    
2. It exposes you to exchange-rate risk. (If the dollar recovers sharply, you could lose a lot of money.)
    
3. It exposes you to other risks that you're probably not adequately familiar with — foreign institutions that might be credit risks and foreign legal systems that might or might not protect your interests — and to costs that might be significant compared to your investment return.

For most people, though, the loss of value in your savings is insignificant compared to the lost of value in your income (which is probably almost entirely in dollars). The only real way to fix that is to get some additional income in euros or yen or yuan — but that's not practical for most Americans.

If you're not an American, you're stuck facing the flip-side of this. Your currency is strengthening, which is great to the extent that imports will be cheaper, but bad to the extent that your (and your neighbor's) livelihoods depend on selling things to Americans.

There are two bright sides to this.

First, a falling exchange rate usually translates into rising prices only gradually. That's not true of commodities like oil, but for other goods, the manufacturers, importers, and retailers usually take most of the loss, at least for a while — in order to keep their market share and maintain good relations with their own suppliers and customers. So, expect the price of consumer goods to lag changes in exchange rates.

Second, for the reasons described above, the Fed isn't completely insane for wanting this. Rising inflation will let the Fed's policy moves gain some traction. A weaker dollar will boost U.S. manufactures. A recovery in the U.S. economy will yield benefits to everyone.

I don't think those benefits will exceed our losses, but they do exist.

After diversifying your income internationally (always hard to do, but worth attempting), your next best move (for Americans) is to find ways to reduce purchases of imported goods. Just using less is always a good idea — the less fuel you burn, the less you have to buy with your weaker dollars. Where you can't (or don't want to) reduce your consumption, source as much of what you buy locally as possible.

And, since those are all good things to do anyway, you can understand why producing a falling dollar isn't a mistake this time. They're doing it on purpose.