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Euro crisis: 'Don't overlook dollar's weakness'

By Simon Derrick
Currency strategist, BNY Mellon

image captionWatch out: The euro may not be the only currency to keep an eye on

Given the scale and complexity of the Greek crisis, it might reasonably have been expected that the euro would have plunged in value against the US dollar, the traditional safe-haven currency in times of uncertainty.

However, although the euro has come under pressure against the US currency since the summer, its losses have proved surprisingly modest.

Does this reflect some mysterious confidence in the outlook for the troubled euro or, instead, a loss of faith in the dollar itself?

The answer, it would seem, is that this probably has more to do with abiding concerns about the buck than any new found faith in the euro.

This can be seen by looking at the dollar's performance against a number of other major currencies.

In the UK, the pound stands a good 5% higher against the dollar than it did on 6 October.

Given that this was the day that the Bank of England announced that it was injecting a further £75bn into the economy, this is telling.

Similarly, despite the tragic events of earlier this year, Japan has found itself fighting against the unwanted strength of the yen against the US currency.

Battling deflation

Why then is this happening?

The answer would seem to lie in comments made by Ben Bernanke, head of the US central bank, at the end of September.

When asked about what people expected inflation to do in the United States, he stressed: "If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation."

In other words, if price pressures started to fall again, then Mr Bernanke would push the Federal Open Market Committee (the US equivalent of the Bank of England's rate-setting Monetary Policy Committee) towards taking measures to ease monetary policy even further. That would mean a third round of the controversial policy of quantitative easing, which creates money and injects it into the economy.

With the Wall Street Journal recently reporting that Federal Reserve officials were poised to downgrade their outlook for the US economy for the next three years, it could be argued that it is now more a question of when rather than if the central bank decides to go down this route.

Although there are differing opinions about whether quantitative easing should have any impact on the value of a currency, history suggests that it does.

Between 2001 and 2006, the yen came under pressure as the Japanese central bank carried out a number of rounds of quantitative easing. Similarly, the US dollar was hit hard following the introduction of quantitative easing in March 2009 and again last year.

Indeed, the only currency seemingly not to have felt the impact of quantitative easing on its value has been the pound. However, sterling is so competitively priced that it could be argued that all it has done is to stop the currency strengthening.

Commodity prices

So why does the risk of a falling dollar matter? The simple answer is that it raises the threat of inflation not just in the United States but also elsewhere in the world.

With most of the world's major commodities still priced in dollars, it is noticeable that any major decline in the value of the US currency has usually coincided with sky-rocketing commodity prices.

This certainly proved to be the case during the first half of 2008 (when the price of a barrel of oil at one point cost an astonishing $145) and again during the first half of this year.

With the headline annual inflation rate in the UK already above 5%, this would present the Bank of England with a conundrum.

Should they react to contain the threat of rising prices by starting to tighten monetary policy or should they, instead, focus on supporting the economy by trying to keep lending rates as low as possible? Either choice would present them with difficulties.

Although the rest of the world may worry about the threat of a weakening dollar, there is little that other nations can do to influence what the US central bank does.

Indeed, the United States and China have clashed over this issue (along with China's currency policy) for a decade and appear to be no closer to resolving the issue.

Until the US finally starts to believe that cheap money is starting to hurt its own economy, it appears that we are stuck with the problem.

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