The Falling Dollar and How It Will Affect You

Those trips to Europe will be more expensive

Frequent travelers to Canada have noticed that in the last couple of years, the U.S. dollar has bought less and less. In fact, once the boss of the Canadian “loonie”, the greenback has been humbled as the tables have turned on it.

As I write, one Canadian dollar fetches an unheard-of $1.05, the crisis-ridden Euro goes for $1.44 and the UK pound commands a stratospheric $1.64. Truly, the once mighty dollar has fallen.

A National Bureau of Economic Research (NBER) study shows that value of the dollar fell 11% against the Federal Reserve Bank’s index of major currencies during the 12 months through May 2011 and 31% during the past ten years.

Of course, the dollar remains the world’s go-to reserve currency and many, if not most countries hold their external reserves in dollars. The price of oil is also pegged in dollars.

The NBER analysis holds that further declines in the dollar are to be expected in the near future for four reasons:

  • A portfolio rebalancing by major international investors who regard their portfolios as overweight dollars,
  • The large US current account deficit,
  • A Chinese policy to raise consumption, and
  • Interest rate differences that make dollar investments less attractive.

To my mind, U.S current account deficits are the major reason for the declines we will surely see in the dollar. The U.S., as part of the QE2 (so-called “quantitative easing”) has basically been printing money to reflate the economy and to pay our oversize bills.

As the price of the dollar sinks, it makes the dollar-based external reserves of foreign countries lose value and oil-based economies also make less for their oil.

Paradoxically, many economists view a declining dollar positively in that it makes U.S. exports more competitive and even locally made goods are more attractive to American consumers over costlier imports.

The risks however, include inflation, based on pricier foreign goods that consumers still buy. Withdrawal of external reserves by foreign countries and diversion of new reserves to Swiss francs and Australian and Canadian dollars (among other currencies) would also lead to higher interest rates as the Fed must offer higher interest rates in order to borrow.

So in short, there is inflation in the forecast and rates will begin to move up faster and farther than we have seen in a long time. Consumers should advantage of historically low mortgage and refinancing rates as these rates may not be seen again any time soon.

However, beware if you plan on traveling to Europe, the Far East, or even Canada. Your dollars will buy you much less than you remember. Same with those expensive foreign cars and clothes. They will certainly cost more. Staycations, anyone?