Dollar’s Slide May Continue for Now

03/13/2008 12:00 am EST

Focus: MARKETS

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of The Kiplinger Letter, says the US dollar will probably continue to fall until the inevitable rebound starts later in the year.

The dollar's dramatic slide is scary. It's part of a nasty downward spiral.

The weak dollar is sending investors scurrying to commodity markets-oil, gold, grains, and more-in hopes of earning higher returns. That fuels inflation, squeezing profits and consumers, discouraging spending and further weakening US economic growth.

The buck probably has further to slip, with the euro rising past $1.60 and the yen likely to hit its highest level since 1995. But the dollar isn't in free fall. And there's little reason to fear a collapse.

The US economy remains structurally sound, though slowed. And if big global investors tried to dump much of their greenback holdings, the rest of their portfolios would crater.

In fact, a healthy rebound is certain: The buck is already below a justifiable level. Something close to $1.40 against the euro makes a lot more sense, given the hard facts.

The big question is the timing of a rebound. It'll take months, and a turnaround may be as far off as the end of the year. The key: positive US news, or at least a halt in the steady march of negatives. Investors need a reason to quit reacting to every drumbeat by shifting assets out of dollars into other currencies or commodities.

Also needed: an attitude adjustment by the European Central Bank. Inflation remains its top concern, not the Continent's sluggish growth. ECB interest rates won't drop-and they may even tick higher-as long as that's the case. And with the ECB and the US Federal Reserve headed in opposite directions, the gap between the dollar and euro will widen. The Bank of England and the Bank of Canada, in contrast, trimmed rates, and the value of the dollar against the pound and loonie has stabilized.

Eventually, inflation worries will ease, soothed by a combination of slow growth reducing demand for commodities and signs of a US pickup.
 
[But for now] the Fed is trapped. It can't halt the dollar's drop. In fact, its efforts to buoy economic growth only feed the decline. Interest rate cuts make the euro and other currencies more attractive and also increase liquidity, fueling inflation and that downward spiral.

Meanwhile, expect another half-point cut [in the federal funds rate] by March 18th, following disappointing data on job growth and factory orders. Fed policymakers may even act ahead of the scheduled meeting and might go for a three-quarter-point cut if market conditions worsen. The Fed is also taking other steps to make more credit available.

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