How the Declining Dollar Affects You and the World
Friday, September 21st, 2007By now most of you probably know that the fed cut 50 basis points off the interest rate on Tuesday (roughly 0.5%). Fed Chair Bernanke did it because he’s concerned about the economy, which really means he’s concerned about bank profits.
Let’s not forget that the Fed is a privately held and unelected conglomerate of banks.
The value of the Dollar has been declining rapidly against the Euro, and in fact is now EQUAL to the Canadian Dollar.
Central banks across the world are divesting of U.S. Dollars and Iran prefers that countries buy it’s oil with Japanese Yen.
There are two parts to this that I’d like to discuss. The first is why cutting the interest rate devalues the dollar, and the second is why Bernanke decided to do it.
Cutting interest rates leads to a declining dollar
Why does reducing interest rates reduce the value of the dollar? The short answer is that U.S. Treasury bonds have a lower yield. Lenders (largely foreign) are less willing to buy treasury bonds at lower rates, and the $2.5 Trillion in federal debt makes them even more skittish.
By the way, that’s $8,300 in debt for each of you. It’s simply insane that Bush can claim to be fiscally conservative, but that’s a story for another time.
Point being that the dollar is earning a smaller return, our trade deficit is huge, federal debt is as high as it’s ever been, and our economy is not doing well. The result is that the dollar is no longer a profitable or safe investment.
As the dollar continues to devalue it gets worse. Foreign investors with dollar-based holdings saw a decline of more than 15% after the rate cut. You might say that the dollar is on the declining side of a decades long bubble, and people are afraid to hold dollars.
Why would the fed cut the rates?
Let’s be clear here. The only concern of the fed is to bail out their banking buddies (Mish). Banks stand to loose incredible amounts of money in the current credit crunch because they lent too much money on assets that were way overvalued. The fed is now trying to fight asset (housing and the CDO mortgage-backed securities) devaluation, and sacrificing the value of the dollar to do it.
By cutting rates, the fed hopes to stimulate buying and investment, and hence stop the deflating assets long enough for the banks to divest themselves.
Since this rate cut is unlikely to do much to stimulate growth, we can expect further rate cuts in the future, and further dollar devaluation.
Some economists argue that a long term decline of the dollar is necessary to right the enormous trade imbalance. It’s nasty medicine. However, no one thinks that a ‘run’ on the dollar would be beneficial to the US or the world.
But a run on the dollar may be just what we see.
The declining dollar and the world
No one wants to hold on to a declining asset. The world has generally regarded the dollar as a very stable and high-yielding currency, but that is not proving to be true anymore.
There are other factors at work to though that might stem worldwide divestment of the dollar. A strong dollar is good for countries that export to the US because they get a favorable exchange rate. But the US isn’t the only major purchaser anymore. The EU is now a larger buyer of Chinese goods that the US, and many other countries have shifted toward being net importers. The result is that China, though still heavily dependent on US consumption, is not as dependent as it once was.
The declining dollar and you
What does a declining dollar mean for you? For most of us it means higher prices. Corn in Chicago went up 3% since Tuesday. Rampant inflation means any wage raises you get are demolished by higher costs.
Those of us on fixed income or in low-paying no-raise jobs, basically the poor, are hurt badly.
Got Investments? The value of your investments are eaten away by the same inflation rates. Lower interest rates mean lower bond yields but generally higher stock prices, though if the economy takes a dive stocks won’t hold up to well either.
So is inflation good for anyone? Not really. It’s least bad for people in debt. I have student loans at 3.25%, and inflation of 3% means I’m only paying 0.25% in interest. The majority of America with large credit card debt and big mortgages will benefit from lower rates and inflation eating out the bottom of their (read: the bank’s) house.
People won’t connect the lower interest rate on their mortgage with the higher prices at the grocery store, and so a credit-addicted public will welcome the cut.
I have a very minor investment portfolio. Earlier I was musing about how to invest in a recession. I’m thinking very strongly of moving to a commodity-based portfolio. My one reserve is that I don’t like to buy when the dollar has already declined so much. I may just stay in my global tech fund and weather the storm.
Brace yourselves…
-zot
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