The weaker dollar will saddle US consumers with mounting bills for everything from gas to groceries, writes Axel Merk of Merk Investments.

Should investors be concerned that a weaker US dollar causes inflation? The price at the gas pump should be a stark reminder that a weaker dollar may contribute to higher prices.

Yet economists tell us that food and energy inflation does not count. Why do economists have such a baffling sense of logic?

When Federal Reserve Chairman Ben Bernanke tells us a weak dollar is not inflationary, he truly means it. And he is right. But possibly also very wrong.

As a scholar, he bases his view on research conducted at the Fed. “Research” refers to a study of the past, with the argument that the past may be the best we can go by in assessing the future.

But Our Economic History Is Only 40 Years Old
Given that our current fiat monetary system has only been in place since Nixon removed the last link to the gold standard in 1971, one needs to consider that we have hardly had enough economic cycles to truly understand all levers that drive inflation and the US dollar. In a world inundated with data, economists are eager to find patterns to extrapolate.

Not surprisingly, I had to endure presentations by very smart Ph.D.’s in the years leading up to the financial crisis who argued that housing prices would never decline: just look at the data! It never happens, not in the US!

The missing piece in the analysis was common sense—but as we all know, it wasn’t just a few that were caught in this trap.

The reason Bernanke is right is because in the past, indeed, a weaker dollar has not necessarily been inflationary. Most notably, the US dollar index almost halved between February and December of 1987. The CPI, however, increased by a “mere” 4.4%.

The main reason why, historically, a weaker dollar may not have been particularly inflationary is that foreign exporters tended to absorb what amounts to a higher cost of doing business in a weak-dollar environment.

Because of competition, foreign exporters tend to be limited to two choices: reduce margins, as exporting to the US becomes less profitable, or stop selling into the US market if it is no longer profitable.

There are numerous ways to manage currency risk: they include hedging in the forward currency markets, but also include moving production to lower-cost countries or the country where the customer is located.

  • Lower-cost countries tend to be the preferred destination for low-end consumer goods. Vietnam has seen a lot of investment as the cost of doing business in China has risen.
  • However, for more value-added goods, producing closer to the consumer often makes sense. Toyota and BMW are two of the higher-profile examples that have built plants inside the US.

Active management of foreign-exchange rates can buffer many risks, leading to a mitigated impact on consumer prices. Having said that, the management of foreign-exchange risk can be an art as much as a science, and mistakes are made.

Chinese businesses love fixed exchange rates because it is one less item to worry about, but conducting business in a world with free-floating exchange rates is a skill learned over time—a key reason why Chinese policy makers are rather slow to allow the yuan to appreciate.

NEXT: Inflation’s on the Way

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