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Exchange Rates and Interest Rates Tell Confusing Story

Posted By J.D. Foster, Ph.D. On October 13, 2009 @ 10:15 am In Economics | Comments Disabled

The dollar’s steady and sometimes fleet downward slide in exchange markets [1] is eliciting a number of interesting explanations, but most commentators are only looking at their favorite piece of the economic puzzle. The dollar is under pressure against, well, every currency that matters. But why, and are there other financial markets oddities demanding attention, like U.S. interest rates?

Part of the explanation for the dollar’s slide is surely the Obama Administration’s pursuit of a wide range of policies sharing the singular characteristic that they would permanently weaken the U.S. economy. Higher taxes on businesses, higher taxes for health care, higher taxes for industrial manipulation in the name of the environment, all insufficient to dent massive deficits are hardly lures for foreign capital.

Part of the explanation may be the dollar was too high against the Euro, the yen, and the Renminbi. The long-running and unsustainable U.S. trade deficit suggests this was so. The Chinese buying a couple trillion in dollar-based assets to prop up the dollar proves this was so. If the dollar was too high, then it should come down. Even a “strong dollar” policy cannot justify a “too strong dollar” policy.

One offered explanation is that foreigners are fleeing the dollar out of fear of resurgent U.S. inflation. The proffered solution then is for the Fed to hike interest rates in the simultaneous defense of a “strong dollar” and against inflation.

But if inflation is such a threat, and it may well be, why then is the 10-year Treasury bond trading at 3.25 percent? It should then be at 5 percent or 6 or higher. Either we are to believe that exchange traders have access to information and knowledge unavailable to the bond markets, or something else is afoot besides an imminent inflation threat.

Why is the dollar falling now? Many possible reasons, but oddly low U.S. interest rates are surely the main immediate and classic reason. The question we should be asking is not about the dollar. We should be asking why the 10-year Treasury is so low.


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[1] steady and sometimes fleet downward slide in exchange markets: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a7mHS_OElufk

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