Interest Rates and the Dollar, July 2007

The dollar will supposedly collapse sometime soon, according to the bears.  That's hogwash, according to the bulls.  Both sides have plausible arguments (...and, by the way, getting to hear both sides of the argument on any given question is the main reason I like to catch Larry Kudlow's CNBC show, Kudlow & Company, whenever time permits—about twice a week; I can't remember the last time he didn't have both viewpoints represented by an expert on the topic at hand). 

I still refuse to get into the game of predicting interest rates or the forex value of the dollar, so I'll just continue to keep a close eye on the indicators, and be content with my role as net judge at a ping pong match.  (If I ever get good at predicting either of those, I'll shut this blog down and start trading futures.)

Anyway, a weaker dollar should in theory translate into higher long term interest rates, and so should higher inflation.  But inflation is staying level at around 2.5% according to most measures; interest rates are moving sideways to slightly up; and although the trade-weighted dollar index is falling, it's still much higher than in previous decades.  In short, dollar doomsday isn't on the radar yet. 

Here are the updated charts; click to enlarge.

Comments

[Bob]

What? No link to Krugman? How can you be fair and balanced?

It's not fair. It's not fair. It's not fair. All must be fair.

(daily mantra of Nancy Pelosi)

[Iago]

Steve -

Your chart of the trade-weighted dollar does not quite match the charts for Euro/dollar, pound/dollar, SF/dollar, whatever/dollar. I have read the definitions for trade-weighted dollar, but understanding eludes me. Can you expand on this topic?

Also, there is a dearth of comment on the recent fall of the dollar. I know European interest rates are up a little, but why did the dollar fall so far, so fast, while our recent interest rates remained quite stable?

[Morgan]

Iago:

The dollar has fallen much more against the "major currencies" weighted index (which includes the currencies you've listed) than it has against the broader trade-weighted index (which includes all major trading partners), and it's the broader index that Steve has shown here.

I don't know exactly why the dollar has fallen so far, so fast against the major currencies (and I believe is at a new low point going back to 1973). We run fairly large trade deficits aginst most of them, but I'm not aware that the deficit has suddenly worsened.

Maybe demand for US assets has dropped. Steve (I think it's Steve, though maybe it's the Cafe Hayek boys) is fond of pointing out that willingness on the part of foreigners to finance a trade deficit is evidence that the US is a good place to invest. Maybe the recent slowdown made it appear less good, and they're demanding better terms through the exchange rate mechanism.

[Iago]

Morgan, thanx.

Trade-weighted, of course! China is one of our biggest trading partners, and the renminbe is closely pegged to the dollar. That means a big chunk of our trade is conducted at stable currency rates, therefore the trade-weighted dollar is more stable than the European currencies in relation to the dollar.

I am still curious about the rapid fall of the dollar, if anyone has comments. The DOW hit 14,000 yesterday, and one of the news services said that there were record inflows of foreign assets into our markets. If that continues, the dollar should stabilize, and perhaps recover.

[Steve]

lago:
Sorry this took me so long. I suggest taking a look at this paper by the St Louis Fed folks explaining the trade weighting algorithm:
http://tinyurl.com/2x5yg2

It's a geometric weighting, not a simple weighted average. I haven't checked their math; I'll trust 'em on this one, and just plot their numbers.