Kurt Brouwer October 5th, 2009
As you know, the dollar has been falling against the Euro and other currencies lately. But, it is sometimes hard to put that in an actual historic perspective. Also, it’s hard to understand why the dollar is falling. With this post, the goal is to give you answers on both questions — How far has the dollar fallen? And why is it falling? And, we also want to discuss what is likely to be ahead for the declining dollar.
Declining the dollar
Do you remember hearing that the Euro fell to historic lows versus the dollar in 2001? In fact, the Euro fell steadily versus the dollar for the first five years of its existence, beginning in January 1999. It did not get back to even until mid-November, 2003. At the low point for the Euro you could have bought one for 84 cents. Now, it takes a $1.46 to buy one Euro.
Here is a chart showing the fluctuations of the Euro versus the dollar since inception in 1999. This shows how many dollars it takes to buy one Euro. When the blue line is heading down, the dollar is getting stronger. When the line heads up, the dollar is getting weaker.
U.S. Dollar / Euro
Source: St. Louis Federal Reserve Bank
The gray bars in the charts indicates the relatively brief recession we experienced in 2001 and the longer recession we are experiencing now. You might notice that the 2001 recession coincided with the low point for the Euro (or conversely, the strongest point for the dollar during this time period). Why? The very strong dollar and the recession went hand in hand because the Federal Reserve raised interest rates beginning in 1999 and that led to the recession. Higher rates cause the dollar to strengthen, but they also inevitably slow down the economy. On the other hand, lower interest rates are positive for the economy, but often not for the dollar.
After the 2001 recession ended, our economy strengthened for years and the dollar fell, more or less continuously during that economic upturn. Coincidence? No. Here is a chart showing the Federal Funds target rate.
Federal Funds Rate
Source: St. Louis Federal Reserve Bank
As you can see from this chart, the Federal Reserve began raising interest rates (blue line going up) to slow down the technology bubble in 1999. By comparing this chart to the first one, you can see that when U.S. interest rates went up, the dollar rose versus the Euro. When the economy fell into recession in 2001 (the first area in gray), the Fed began slashing interest rates and the Euro finally began strengthening versus the dollar. The Fed began raising rates again in 2004 due to inflation concerns and the Euro stabilized versus the dollar until the Fed stopped raising rates in 2006. At that point, the Euro began climbing and the process accelerated when U.S interest rates were cut significantly in 2007 as the economy began to weaken.
Flight to the dollar during financial panic
During the financial panic at the end of 2008 and early in 2009, the dollar strengthened considerably. This chart is the same data as in chart number one, the dollar versus the Euro, but for the period of 2008 and so far in 2009. I also took off the recession bar. Remember that the blue line going down means the dollar is strengthening versus the Euro, while the blue line going up means the dollar is weakening.
Source: St. Louis Federal Reserve Bank
The flight to the dollar during the panic began in the Summer of 2008 and ended in early 2009. As the panic subsided, other considerations such as interest rates took hold again and the dollar again began to weaken against the Euro. At the low point, it took nearly $1.60 to buy one Euro. Then, during the depths of the financial panic, it took only $1.25 to buy one Euro, but now that same Euro would cost $1.46 or so.
What’s Next?
The big difficulty we face now is that the economy is weak and the Fed likes to have low interest rates to help the economy begin to grow again. Low interest rates are helpful to overall economic activity, but, as you have seen, lower rates generally hurt the dollar. If we wanted to help out the weak dollar, the response would ideally be to raise interest rates. However, due to serious weakness in the economy, the Fed is hampered in its ability to respond to this situation and I believe it will opt to keep very low interest rates in order to promote economic growth.
You may hear various members of the Federal Reserve or politicians or pundits decrying the weak dollar. However, for decades, our government’s philosophy during recessions has been to publicly espouse a strong dollar while, at the same time, cutting interest rates to strengthen the economy and give unemployment a boost. This has traditionally been done despite the fact that lower interest rates generally lead to a weaker dollar. I don’t see anything in the cards that appears to have changed that policy. Therefore, I expect continued pressure on the dollar as the Fed seeks to get economic activity going again.
