Saturday, May 17, 2008

The Fed is partly to blame for the slide of the U.S. dollar

A slowdown in foreign economic growth from key economies is beneficial to the U.S. because the value of the U.S. dollar (US$) would rise. Unfortunately, key foreign growth has not slowed enough and the US$ will likely remain at a low value (depreciated) for some time. The Federal Reserve Bank (Fed) was too loose in its recent monetary actions (lowering the interest rate 3.25% since September 2007), quickening the slide of the US$.

Since 2005, the US$ has been steadily losing value relative to many of our trading partners. Recently, the US$ bounced back against the Japanese Yen, but continues to lose value against other key currencies like the Chinese Yuan, British Pound, and the Eurozone Euro.

Source: data from Federal Reserve Bank of St. Louis

There are three culprits of the depreciation US$:

  1. The slowdown of the U.S. economy.
  2. The rising price of crude oil.
  3. The Fed’s decisions to lower the interest rate.

1. Foreign investors became nervous about U.S. investments when the sub-prime financial crisis began in August 2007 and the U.S. economy slowed. As the expected economic strength of the U.S. declined, foreign investors across the world sold off U.S. assets (stocks and bonds), and consequently, flooded the foreign currency market with US$. The value of the US$ declined sharply.

2. The rising price of crude oil has had a significant impact on the value of the US$ because the world buys and sells crude oil in US$. So, as the value of the US$ falls, sellers of crude oil raise their price in order keep profits at the same level. Foreign economies with the bulk of the oil reserves (Saudi Arabia, Qatar, Venezuela, United Arab Emirates, Kuwait to name a few) have raised the price of oil in order to accommodate a declining US$. It should be noted here that this is different from OPEC (the above countries are members of this organization) cutting production to drive up the price of oil.

3. Recent actions by the U.S. central bank (the Fed) has had a substantial impact on the value of the US$ since September 2007. Commencing on September 18, 2007, the federal funds rate, the Fed’s target interest rate, has fallen from 5.25% to 2%.

  • The Fed lowers its target rate in order to stimulate a similar downward-momentum in other rates that apply to businesses and consumers.

Saving rates fall, car loan rates fall, mortgage rates fall, and consequently, people save less and buy more cars and more houses, etc. This is good for the economy if it is in a rut. Likewise, lowering the federal funds rate also causes foreign investors to sell off US$. As saving rates fall with the lower interest rate, foreign investors pull out of the U.S. financial markets, dragging down the value of the US$.

The only way to counteract the Fed’s cause of the falling US$ is for other key economies to lower their target rates as well. For example, if the European Central Bank (ECB), the central bank of the Eurozone, lowered its target rate, then there would be no need for investors to move money from the U.S. to Germany (let’s say) because both saving rates are falling. So, we hope that growth in foreign economies slows enough to force important foreign central banks to lower their target rates.

The Bank of England has lowered its policy rate, but just by 0.75% since March 9, 2007. The ECB has been reluctant to lower its rate, sticking with 4.0%. But this is not enough. If growth in these economies suffers, then the central banks may be forced to lower their target rates. Unfortunately, growth is stronger than expected in the U.K., Canada, the Eurozone, and Japan, and amid the high global inflation rates, there is no imminent need for the central banks to lower their interest rates.

The Fed lowered interest rates too much. It certainly has control over their policy rate, but has no control over the price of oil or growth of key foreign economies. It was just too much.

Thus, the US$ will maintain its depreciated value until one of the following happens:

  1. The U.S. economy improves significantly – unlikely for a while (at least into 2009)
  2. The pressure on the price of crude oil falls – unlikely for a while (perhaps back to $100/barrel by the end of 2008).
  3. A global economic slowdown occurs – not looking good.

Please leave any comments that you may have. Nontruths

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