What The Weak Dollar Means for You
Paul L. Kasriel, Northern Trust Corp.

The dollar's recent strength — it reached a seven-month high of 0.79 against the euro — won't last. Going forward, it will resume its decline against the euro and Japanese yen. In January 2002, one dollar was worth 1.1 euros. By early April 2005, a dollar bought only 0.77 euros. So far, the impact has been felt most by American tourists in Europe, but soon the weak dollar will affect even Americans who stay home.

Interest rates are likely to continue to rise. The falling dollar is not the only reason — the Federal Reserve has been raising rates because it is worried that the economy may grow too fast and fuel inflation. However, the falling dollar will play a major role. It makes imports more expensive, which creates inflation.

ROOT OF THE PROBLEM

For years, American consumers have had an enormous appetite for imports, using dollars to buy goods. Foreigners, in turn, purchased US stocks and bonds. Lately, the foreign appetite for US financial assets has waned. US Treasury yields are low, and foreigners hold vast quantities of our bonds. This has resulted in less demand for dollars and dollar- denominated assets. Whenever demand for a commodity falls, the price drops. That's what has happened to the dollar. Its retreat has been gradual because foreign central banks in China, Japan and other countries are buying US Treasury bonds and other dollar assets.

Reason: Foreigners don't want a sharp drop in the dollar, which could cause the American economy to go into a tailspin. US trading partners — Chinese factories, for example — would suddenly have fewer customers.

Our mutually supportive relationship with foreign central banks has protected America's recent economic expansion by helping keep interest rates low, but that could change. Instead of just buying Treasuries, central banks could direct financial muscle toward cooling down their economies to fight inflation. Alternatively, central banks could use their influence to slow their economies. In China, for example, the government is not allowing banks to make as many loans. This will slow the economy before consumer demand for goods and services begins pushing up inflation.

CREATING INFLATION

Besides making imported goods more expensive, a falling dollar raises the price of raw materials that are used to produce manufactured goods.

In addition, the falling dollar makes US goods cheaper for foreigners. That increases demand for US exports. The added sales put upward pressure on prices. The US Consumer Price Index has been rising at an annual rate of 3% this year, up from a rate of 1.6% in 2001.

Partly to address inflation concerns, the Federal Reserve (our own central bank) has been raising short-term interest rates — and rates on longer-term bonds are likely to follow suit. By the end of 2005, yields on 10-year Treasuries could reach 5%, up from 4.1% now. Rising rates will slow the economy, though there won't be a full-blown recession.

WHAT TO DO

Travelers. If you want to visit Europe and/or Japan, go soon, before the dollar weakens even further.

Home owners. If you have an adjustable-rate mortgage, consider locking in a fixed rate before rates go up.

Investors. Buy foreign stocks and bonds. If you do so through mutual funds, find ones that don't “hedge” currency. As the dollar falls, the value of foreign holdings will rise for US investors. In the past year, foreign stocks have outperformed American stocks largely because of this currency effect, and this outperformance will continue.

Credit card holders. Pay down balances quickly, before rates rise.

CD buyers. Don't buy certificates of deposit with maturities of longer than six months. Hold out for higher rates.

Bottom Line/Personal interviewed Paul L. Kasriel, senior vice president and director of economic research for Northern Trust Corp., one of the country's largest asset-management firms, Chicago.