In our 2004 study “The Dollar vs. the Euro: How Low Will It Go?” we discussed three reasons for the decline in the value of the dollar—short-term interest rates, the trade deficit, and the budget deficit. Eight years later the global economy has experienced the deepest downturn since the Great Depression. The U.S. economy is finally showing signs of life, but the forecast for the next few years is slow economic growth. Given this environment, let’s re-examine the future of the dollar.
The FED set its target for the federal funds rate at a rock-bottom 0 to 0.25 percent to stimulate the economy. But the FED did not stop there, it pumped trillions of dollars into the financial system. This caused the FED’s Balance Sheet to balloon and many worry about the FED’s ability to safely unwind its programs.
As the economy began to recover and consumers have begun to spend, the deficit has started to grow. The government must raise funds to finance the deficit. In the past, Asian Central Banks have financed the deficit to support the dollar against their currencies, however there are signs that this support may decrease in the future.
The U.S. budget deficit continues to rise and shows little sign of diminishing. While individual and corporate income taxes should increase with economic growth, government expenditures continue to increase due to the lingering recession and continuing terrorism threat. But the federal government isn’t the only one facing budget strains. Many states face gaping holes between revenue and expenses. After three bad years in the economy, many of the “easy fixes” have been closed and states face large cuts in education and services. In addition, government-sponsored agencies (GSA), particularly Fannie Mae and Freddie Mac, face large deficits.
So, what does this mean for the future of the dollar? The euro has lost much of its shine given the continuing worries about the ability of the Eurozone to survive in its present form. However, this does not guarantee support for the dollar or the U.S. economy. Risk adverse investors are currently parking their money into U.S. Treasury bills because they are the safest, most liquid, short-term instruments available. But when the appetite for risk returns, investors tend to sell the dollar. And if Europe solves its financial crisis, the euro may rise again to challenge the dollar.
To return to our original question, how low will it go? The U.S. faces several significant challenges as the economy slowly emerges from the Great Recession. New asset bubbles encouraged by low interest rates and the growing trade and budget deficits must be addressed to sustain the economic growth. This will determine the value of the dollar in the future.