LONDON () -- The value of the dollar sank to a record low against the euro on Friday on the back of poor U.S. economic growth numbers combined with evidence that inflationary pressure in the U.S. economy continues to build.
Growth in the U.S. economy decreased to 1.3% in the first quarter of this year, compared with 2.5% in the final quarter of last year. Growth is now at its slowest in four years. At the same time the personal consumption expenditures index, a widely watched inflation gauge for the U.S. economy, increased 2.2% in the first quarter - above the 2% maximum that the Federal Reserve is likely to be comfortable with.
This puts the Fed between a rock and a hard place with regard to interest rate policy. A cut in interest rates will undermine the dollar and increase inflationary pressure by causing import costs to increase. On the other hand, an interest rate rise will help control inflation but will strangle economic growth.
In addition, protectionist measures targeting goods from China being proposed by some U.S. lawmakers will make inflation worse if they are implemented, as any increase in import costs due to tariffs or other measures will eventually be passed onto domestic consumers in the form of higher prices.
Would imports be discouraged? Perhaps, but any effect involves a time lag, and there are only some goods now imported that could be economically produced in the U.S. even with the aid of protectionist rules. Not to mention that higher cost production in the U.S. would again add to inflationary pressure. More likely anyway is that any shift in procurement would simply be to suppliers from another foreign country, but even this incurs costs that will be passed on to consumers and contribute to inflation.
Consensus opinion currently seems to favour falling rates in the U.S., with weakness in the housing market a particularly strong motivator for a rate cut, but at the same time it would be unwise to underestimate the Fed's zeal for combating inflation.
Although the U.S. economy is weakening, the Fed could still prioritise inflation control, but it may come under quiet pressure from the current U.S. administration to delay any counter-inflationary rate hikes until after the next presidential elections.
As well as the falling dollar, inflation is being fed by sustained high oil prices and the end of the period of falling prices for manufactures that was created by China's entry into the world economic system.
Inflation has been held in check for some years by the latter, but now that the holiday is over, the arrival of high oil prices, ironically due in large part to increasing Chinese demand, and the weakening dollar means that the U.S. economy is now subject to a three pronged inflation threat.
There is an ever present threat to the dollar of diversification towards other currencies by current large holders; exporters in East Asia and to a less extent the petrostates, mostly in the Middle East. The most important dollar holder is China, but the beginning of substantial diversification by any significant holder will likely trigger a rush out of the dollar and towards alternatives.
The value of the greenback would plummet in response and the cost of imports to the U.S. would rise, making inflation the most pressing economic issue facing the country bar none. Then the Fed would really have a conundrum on its hands - cut rates to support the economy but guarantee runaway inflation, or hike rates to control inflation and end up with stagflation, in other non-existent growth with high inflation. Not a very nice choice to have to make.
