Thursday, March 13, 2008

The Weakening Dollar and Commodity Prices

From IBD:

Analysts name the weak dollar as one of the reasons for the hot money that has flooded commodities this year. Since raw materials are basically traded in the U.S. currency, any weakening of the currency is usually followed by an upward adjustment in prices.

Economists have said that if the dollar were to strengthen, and the ailing U.S. stock market to rebound as well, some of the money in commodities could return to currency and equity markets. So far there's been little evidence of that happening, even with Tuesday's Federal Reserve plan to provide $200 billion to cash-starved credit markets.

One of the drawbacks of having the dollar be the currency in which most commodities are priced is the dollar's value has a strong correlation to the price of commodities. When the dollar drops in value, commodities become less valuable; they need to increase in price to simply tread water value wise.

This is one of the reasons why the Fed's rate cuts are so incredibly dangerous. As the Fed cuts rates, the dollar become less attractive. One of the reasons people invest in a country is the rate of return they can get on the assets they park in bank accounts. So right now traders are looking to the rate cuts and saying, "rates are higher somewhere else." Add to that the overall condition of the US economy, and you have a place people don't want to invest right now. Therefore, dollar demand drops as does the dollar's price.

Bernanke has obviously decided he can live with a higher inflation rate. But the big problem is how far out of control can you let inflation go before you have to play catch-up?