Dissecting the Declining Dollar

The ever weakening greenback could have further to fall.

By + More

As any American who's recently been to Frankfurt can tell you, the bratwurst is as tasty as always, but it sure is expensive! The sticker shock, of course, has less to do with the quality of the pork than the eroding value of the U.S. dollar vs. the euro, as well as the Japanese yen. The greenback has been slipping in value since 2002 but has hit historically low levels in recent days. U.S. News explores the reasons behind the dollar's dive and the outlook for the future.

How weak has the dollar become?

The dollar recently made record lows against the euro, while hitting its lowest level against the Japanese yen since 2005. At the same time, the U.S. dollar index—which measures the greenback against a basket of other currencies—has declined about 4 percent this year and roughly 12 percent since the end of 2006. What's causing the decline?

Central banker disunity. There are a host of factors behind the decline in the dollar, not the least of which is the divergence of U.S. monetary policy from the rest of the world's. In the face of slowing economic growth, the Federal Reserve has moved aggressively to lower interest rates, slashing the federal funds rate to 3 percent from 5.25 percent in September. But other central bankers have been much less willing to follow suit, amid concerns about inflation. The European Central Bank, for example, has maintained its key interest rate at 4 percent, while the Bank of England's rate stands at 5.25 percent. "The fundamental factor driving the dollar down is interest rate differentials between the U.S. and its major trading partners," says Adam Hewison, a former currency trader and current president of INO.com, a financial trading strategy website. Slow growth. Flagging economic growth in the United States has hurt the dollar as well. "If you are going to have slower growth, there should be less of a demand globally for U.S. dollars," says Joseph Brusuelas, chief U.S. economist at IDEAglobal Inc.

Fed outlook. Furthermore, sluggish growth increases the likelihood that the Fed will continue its rate-cutting campaign, putting additional downward pressure on the dollar. "The Fed has cut rates significantly—225 basis points—we think they'll [cut]...before it's all said and done, down to 2 percent," Brusuelas says. "And that is dollar negative."

Credit contagion. David Resler, chief economist at Nomura Securities, says the housing-triggered credit crisis is another key factor behind the dollar's dip. "It weakens the dollar because it discourages investors from buying dollar-denominated assets," Resler says. "That's led to a kind of reluctance to invest in the U.S. markets."

Trade gap. The ongoing trade deficit for goods and services—which stood at more than $700 billion in 2007—has played a role as well. Although it has narrowed recently, the gap works to increase the supply of dollars in the global financial system, which pulls the currency lower.

Currency diversification. Ken Mayland of ClearView Economics says that world central banks' efforts to diversify some of their reserve holdings out of U.S. dollars and into other currencies—such as the euro—have also contributed to the decline. "The profound weakness of the dollar over the past year only further encourages the desire to diversify more," Mayland says.

So what's ahead for the dollar?

With the outlook for growth deteriorating and the Fed poised to cut interest rates further, greenback watchers don't see the dollar's decline turning around anytime soon. "We expect the dollar to be rather weak this year, especially through the first six months of 2008," Brusuelas says. Meanwhile, Michael Englund, the chief economist at Action Economics, says the dollar could experience a two-year-long downward trend before hitting bottom. The trough will occur at the start of the next period of economic expansion in the United States, Englund says. What does a weak dollar mean for the economy?

The currency weakness can hit the U.S. economy in the form of inflation, as imports become more pricey in dollar terms. "For example, Chinese products are getting more expensive at the Wal-Mart," says Peter Morici, a professor at the University of Maryland's business school. The falling dollar is also fueling speculation in commodities like oil, another source of inflation that is sapping U.S. consumer buying power. But it's not all bad news. By making American products cheaper overseas, the soft dollar has increased demand for U.S. exports around the world. As a result, exports have emerged as the silver lining in the otherwise cloudy U.S. economy. "It's a powerful shock absorber for the economy," says Englund, who calls the weak dollar a "net positive" for growth in the U.S. economy.