What can we expect in a US dollar decline?

December 13th, 2006

Share |

Yesterday, we mentioned about the possible scenario of a decline (or collapse) of the US dollar in Will the US dollar collapse?. Today, we will look at the consequences of such an eventuality.

As we explained in The Bubble Economy, the reason why monetary inflation had not led to severe price inflation is because of the disinflation effect of cheap Chinese imports. Thus, goods that can be imported from China have their prices being suppressed from inflating. However, goods and services that cannot be imported will suffer price inflation, most notably housing and health care. Thus, the US had been printing money and buying goods overseas with their printed money. Simultaneously, the excess printed money went into assets (housing) to cause price bubbles.

Now, as the US dollar decline, that will result in imported goods getting more expensive for American consumers. Since the US import far more than they export, the outcome will be price inflation for those imported goods. When that happens, the Federal Reserve will be forced to raise interest rates to curb inflation. If the Federal Reserve does that, Wall Street will take a big hit, perhaps triggering a sell-off in the stock market since they are expecting the Federal Reserve to cut interest rates in 2007. We guess Ben Bernanke must be in a dilemma and losing sleep over this scenario. If the Fed raises interest rate, it will probably push the already weak US economy into recession. If it does not, the result will be inflation, which if left unchecked, will lead to hyperinflation. That could be the reason why the Fed had been exasperatedly warning about inflation (i.e. interest rates could still rise) in an apparent attempt to shake off the market?s expectation of an interest rate cut next year.

The ideal outcome will be for the US dollar to decline so gradually that the US economy will have plenty of time to wean itself from cheap Chinese imports. But if some financial accident occurs and the US dollar collapses, the outcome will be unthinkable.

Tags: , ,