Dollar value uncertain - inflation and recession or healthy economy coming?

The dollar has slipped to the lowest rate against the Euro ever (1.4481 dollars will buy one Euro today), and the recent interest rate cuts by the fed (required to keep the economy out of recession) will cause the dollar to drop even further.

How does the dropping dollar effect people?

BBC News provides a few examples of that this means for international businesses currently writing new contracts:

• Brazilian supermodel Gisele Bündchen is requiring that all her new contracts be written so that she is paid in Euros rather than dollars.
  
• Billionaire investor Warren Buffett is buying investments that pay in currencies other than dollars.
  
• Jim Rogers, a former investor partner of George Soros, recommends that anyone buying currency now buy the Chinese renminbi, the Japanese yen or the Swiss franc rather than the dollar
  

So savvy business people do not know what the dollar is going to do. Their solution is to sell dollars and buy other currencies.

Supply and demand says that if everyone prefers to sell one currency and buy others the currency being sold will drop in value while the others will go up in value. That action will reinforce what is already happening. The dollar is already in uncharted waters, so there is no telling how much more it will drop.

How does the dropping dollar effect the economy?

This drop in the dollar value will ultimately make American exports less expensive to foreign buyers and cheaper than similar products from competitors, so exports are likely to increase. However, it's not like there are warehouses full of American-made widgets sitting around ready-made and looking for foreign buyers. The export products will have to be produced, and that takes a while. Expect employment to increase because of any increase in exports, but not immediately. [*]

What will happen immediately is that imports will go up in price, with oil being the first and most noticeable increase. That means pressure for inflation. Money lenders will increase interest rates to protect the value of their loans from the anticipated inflation. This is exactly the opposite of what the fed has been doing - which is lowering interest rates to avoid a recession.

Keep in mind the time lag between the time interest rates and the dollar value change and the time exports can be ramped up and help the American economy. This time lag is going to be important.

The Fed's bind

So the fed is in a bind. A looming recession demands lower interest rates. But it also lowers the value of the dollar against other currencies, contributing to inflationary pressures. Inflation will cause interest rates to go up (whether the fed acts or not because lenders increase interest rates to protect themselves from loss of value of their loaned money caused by inflation. That interest rate increase will increase pressures leading to recession.

What does this mean?

Here's where that time lag between financial changes and changes in the rate of production of real goods and services will be important. If exports create enough new employment fast enough, then the fed might be able to head off inflation through an interest rate boost. That depends on whether the economy itself is getting more active rather than heading towards recession. Remember, interest rate changes and changes in the value of the dollar happen rapidly. An improvement in the economy is a lot slower. The fed's goal is to keep the economy out of recession while avoiding inflation that would cause the lenders to jack up interest rates.

I think the fed is going to have to stick with lowering interest rates to avoid recession and hope that the economy will rebound rapidly enough so that lenders don't demand an interest rate increase to protect their loans from inflation. There appears to be at best a very narrow range of options that allow the fed to thread the needle between causing recession by raising interest rates and permitting inflation by lowering them. But that's just my guess.

It may not be possible to maintain that balance. It will only be possible if the lag time between financial changes and the actual production of goods and services for export is very short.

This is, as I said, my guess. If anyone knows which way this is going to work out and has money to invest, they are going to make a lot of money. I don't know what is going to happen, and apparently Warren Buffet doesn't either -- so I don't feel too bad about not knowing. But the fed chief, Ben Bernanke, is facing a great deal of uncertainty which I am sure he wishes would resolve itself quickly.

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[*] While total employment can be expected to increase as exports increase, there are a lot of people who have quit looking for work and are not counted in the unemployment statistics. If employment increases, many of them can be expected to reenter the workforce and start job hunting, so the unemployment rate may not drop.

If the unemployment rate does not drop, that's good. The statistic - the unemployment rate - was designed to predict inflationary pressures. The lower the unemployment rate goes, the more likely we are to get inflation in the economy caused by labor wage rate increases as employers raise wages in an effort to attract more of the scarce workers.