Watch the dollar in 2007

The economic question that should be foremost in everyone's minds right now is the dollar exchange rate. Here (from the Guardian) is one view:

The really crucial question for 2007 is whether it is the year when there is a run on the dollar. There are plenty of people out there - me included - who think the US currency is going to take a beating over the next 12 months.

Here's why. Over the past decade, the dollar has had two big strengths. Firstly, it has been the world's only reserve currency: secondly, its economy has grown far faster than its two big rivals in the developed world - Europe and Japan. Neither of these factors is now as powerful as it was even a couple of years ago, the last time the dollar had a real wobble on the foreign exchanges.

The advent of the euro has meant foreign investors now have a choice of currencies in which to hold their reserves. To be sure, they will still continue to stash away plenty of greenbacks, but the balance is likely to change over the year. Iran's announcement that it was diversifying its portfolio was clearly a political shot across Washington's bows, but it was significant nontheless. Central banks around the world no longer have to load up on dollars simply because there is no alternative; the euro is one, the Chinese yuan will soon become another.

As far as the economy is concerned, the strong dollar has allowed the US to live beyond its means for far longer than has been healthy either for America or the global economy as a whole. A high dollar meant exports into the US were cheap, and that kept both inflation and interest rates low. Easy credit terms meant that the US has had not one but two speculative booms over the past decade, the first in dot com shares, the second in the housing market. Growth has been artificially boosted and the trade deficit has exploded.

Now, though, things have started to change. The US economy has slowed down markedly during 2006 as the housing bubble has collapsed and the eurozone has put in a decent performance for a change. The move from dollars to euros is perfectly rational when looked at on economic grounds.

My real concern is that as the dollar falls, foreign imports will become more expensive. That will put an inflationary pressure on the American economy.

The Federal Reserve under Ben Bernake measures its success by how well the bond market is, and inflation hurts the bond market. That will cause the Fed to increase interest rates. But increased interest rates will reduce the economy, the first casuality of which will be creation of new jobs. So unemployment will increase.

Go read the full article. It gives an excellent view of what is abour to happen.