The value of U.S. currency might seem trivial in the face of soaring gas prices and high unemployment, but the ripple effects of a chronically weak greenback impacts consumers both here and abroad. The U.S. Dollar Index, which tracks a basket of foreign currencies, has fallen almost 5 percent year-to-date. Despite a recent rebound, just last month it tumbled to levels not seen since the worst days of the financial crisis in 2008.
But how did the dollar drop to this point, and more importantly, how much should you worry?
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The answer is complicated, but it has much to do with fundamental supply-and-demand dynamics, says Adolfo Laurenti, deputy chief economist at Chicago-based financial services firm Mesirow Financial. Stronger economies tend to attract investors, putting pressure on the supply of that country's currency and driving up its value. "The stronger the country's economy, the more people want to go and invest in that country and the stronger the currency is expected to be," Laurenti says. On the flip side, investors tend to avoid struggling economies, which lessens demand for investment in the country and weakens its currency.
The Federal Reserve's bond buying programs have also had a hand in pushing the dollar lower by driving interest rates to all-time lows. While meant to reduce the cost of borrowing to spur economic growth, low interest rates have stunted yields on financial products such as bonds, reducing demand for investments denominated in dollars and weakening the currency.
"What we're seeing now is that other economies, as they come out of recession faster than we are and [are] experiencing more robust growth than we are, their central banks are starting to tighten and raise interest rates making those countries look more attractive," says J. Bradford Jensen, associate professor of international business and economics at the McDonough School of Business at Georgetown University. "They might sell U.S. dollar-denominated assets to purchase assets in other currencies, which puts downward pressure on the dollar."
The specter of inflation also remains on investors' minds. "The Fed's bond buying created very low interest rates and created fear for many investors that future inflation will go up," Laurenti says. "Higher inflation expectations and lower yields on financial assets tend to bring weaker currency, and that's exactly what we are seeing for the dollar."
But investors aren't the only ones who have to worry about the impact of inflation. Consumers, too, are bound to see the cost of goods inching up if the dollar remains weak. Although weaker currency helps exporters by making U.S.-produced goods more attractive in the global market, it also makes imports more expensive. U.S. companies can only absorb those higher costs for so long before they start passing hikes on to consumers.
"If you buy goods from abroad and their price continues to escalate, sooner or later, those rising costs will need to be offset in the United States by passing higher costs to the consumer," Laurenti says. "That would, in turn, generate higher inflation." Higher inflation erodes the purchasing power of consumers, which could put strain on the U.S. consumer spending-driven economy.
A weak dollar is a double-edged sword, says Axel Merk, founder of Merk Investments and author of Sustainable Wealth. U.S. exporters might see a bump in quarterly earnings as a result of a weaker dollar, but the benefits will be short-lived, he says. The fundamental issue, Merk says, is that advanced economies rarely compete on the prices of goods, because they can't. "When you think of low-end consumer goods that compete on price, you think of Vietnam," he says. "We have no chance to compete with Vietnam. We have to compete in high tech. We have to compete on value added."