This chart is arguably the best measure of the dollar's value relative to other currencies. It compares the dollar to a large basket of trade-weighted currencies, and it is adjusted for relative inflation differentials. This eliminates the distortions which come from, for example, a large nominal rise in the dollar against a currency that is suffering from very high inflation: if the dollar's rise offsets the effects of that currency's inflation, then the dollar has not really risen at all. Similarly, it corrects for large depreciations of the dollar relative to currencies (in particular the yen) that have enjoyed lower rates of inflation than the U.S.

The latest data from the Fed show that the dollar has once again—for the fourth time since the early 1970s—hit bottom. It is now as effectively weak as it was in Oct. '78, Jul. '95, and Apr. '08. Put another way, a U.S. tourist traveling around the globe today would find that his dollar has never bought less. For that matter, a dollar today has never bought less gold, fewer industrial commodities, or a smaller basket of consumer goods and services.

To say that the U.S. economy is at risk of deflation, at a time when the dollar has never been weaker, is nothing short of cognitive dissonance. One wonders what, exactly, the Fed is looking at when they reason that a bold, risky, and unprecedented experiment in monetary expansion (i.e., QE2) is justified. When the dollar's value is at an all-time low, it follows that there has never been such an oversupply of dollars relative to the world's demand for dollars as there is today. There are more than enough dollars flooding the world already; we don't need even more.

The market is smart enough to figure this out, of course, and that is undoubtedly one of the reasons the dollar is so weak today. Given the prospect of more dollars being dumped into the system tomorrow, the market's demand for dollars has already declined, depressing its price. So the real key to the impact of QE2 will be how it compares to what the market has already priced in. It remains my belief that the reality of QE2 will prove to be less than the anticipation. The Fed will not remain oblivious to the monetary realities forever, and the U.S. economy is already stirring in anticipation of a positive course correction in fiscal policy.

We have survived similarly weak episodes in the dollar before without a devastating rise in inflation (with the notable exception of the late 1970s, when inflation rose to the low double-digits following the dollar's plunge in 1978), and there is no a priori reason we can't do it again.

This post was published at the author's blog >