The stock market faced another setback yesterday. While we won’t dwell too long on it, it’s clear that a shift is underway—one can sense it in the atmosphere. The challenge lies in adequately preparing for these changes, both for opportunities and protection. Here’s what we mean…
In recent months, the U.S. dollar has strengthened against multiple currencies. The dollar index—reflecting the value of the U.S. dollar relative to a selection of foreign currencies—hovered around 80 during the first half of the year. However, since July, it has seen a notable rise.
Presently, the dollar index sits at approximately 86, signaling a 7.5 percent increase in value in the foreign exchange market over the past three months. What implications does a stronger dollar carry?
There are both benefits and downsides to a stronger dollar, depending on one’s viewpoint. For the average saver and consumer, a more robust dollar is generally advantageous, leading to cheaper imported goods. This makes purchases at stores slightly more affordable. On the flip side, it complicates matters for U.S. exports, as American-made products become pricier abroad, potentially reducing their demand.
A significant concern associated with a stronger dollar comes from the Federal Reserve. A powerful dollar tends to lower inflation rates, and if this strength escalates rapidly, it could even lead to deflation.
Fed Headwinds
The Fed is staunchly opposed to deflation; its preference leans towards inflation. As a consistent creator of credit, the Federal Reserve relies on sustained inflation—typically targeted at 2 percent annually—to alleviate public and private debt burdens.
Even a slight decrease in inflation or a hint of deflation could jeopardize the precarious credit structure built on accessible loans and soaring asset values. This scenario could prompt a surge in bankruptcies, as borrowers might find themselves in debt exceeding the worth of their assets, ultimately harming banks and lenders who extended questionable loans.
Recently, the Fed expressed its concerns regarding the strong dollar…
‘“A stronger U.S. dollar poses a challenge for the Federal Reserve’s ability to achieve its inflation targets and will hinder economic growth,’ noted Charles Evans, president of the Chicago Fed, during a recent speech at the International Monetary Fund’s annual meeting.
‘“It is indeed a headwind,’ Evans elaborated to reporters. ‘A higher dollar will impact our net exports, leading to a slight reduction. Additionally, it may contribute to lower import prices, resulting in decreased inflation data.’”
The Solution to Deflation
What Evans fails to mention are the negative repercussions stemming from the Federal Reserve’s inflationary policies for workers and savers alike. It’s crucial to understand that inflation acts as a silent tax on savers, gradually eroding their purchasing power.
Consider retirees depending on fixed incomes or diligent individuals saving for their futures. The effects of inflation are akin to navigating against a strong headwind, subtly wearing away hard-earned savings.
To the monetary policymakers, however, inflation remains the ultimate objective. In a world inundated with debt, the avoidance of deflation is considered paramount.
With QE3 set to conclude this month, the financial system has become increasingly reliant on these ongoing liquidity injections. A stronger dollar might provide the Federal Reserve with justification to initiate QE4.
Ultimately, the Fed is compelled to generate monetary inflation to avert the collapse of the current financial system. This aligns with the Keynesian perspective: inflate or face dire consequences.
Sincerely,
MN Gordon
for Economic Prism
