Monday, August 04, 2003

While most Americans have let their eye roam and are no longer closely watching for signs of deflation, the end of the dollar's sharp fall earlier this year suggests it's far too early to relax.

As Stephen Roach points out today, a falling dollar is an essential part of a global readjustment strategy, but without higher demand in the rest of the world, a falling dollar is likely to simply export deflation rather than spur realignment.

But there is probably little chance of either since the dollar has stopped falling. In February 2002 the broad dollar index hit its peak of 130.45. Then it began its long slide down to 117.16 on June 16. This was a meager 10% decline, and since mid-June the dollar has not just stabilized but actually risen, to 120.14 on August 1 -- cutting the overall decline to just 8%. The major currencies index fell a much sharper 20% (due to factoring out many East Asian currencies which are fixed or heavily managed vis-a-vis the US dollar), but has since risen, too, and cut that fall to just 16%.

Without a much more significant decline in the relative value of the dollar, there is no hope for any reduction of the massive US current account deficit. No reduction means more and more capital needs to flow into the US, which will only place further pressure on US interest rates to rise as foreign capital demands more and more 'insurance' against currency risk in light of the ballooning current account deficit. Higher interest rates mean less demand, and in the midst of rising production, that signals more disinflation.

Without a falling dollar, US deflation will stay right at home. Don't take your eye off falling prices just yet.


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