The dollar has been on a long term downward spiral ever since reaching a peak in 2001. The most recent plunge has been caused by a growing disconnect between the U.S. and the rest of the world. This disconnect is a result of the following factors:
- A surge in commodity prices and signs of overheating of the economy in emerging markets is prompting a growing chorus of central banks to tighten rates. The ECB was the latest to raise rates last week in response to a commodities fueled steady rise in headline inflation.
- The second round of quantitative easing still has a couple of months to go and there is talk of a possible third round if things dont improve.
- A U.S. government shutdown may have been narrowly averted but the upcoming confrontation on raising the debt ceiling would have far greater consequences in the event that an agreement is not reached by around May 16 in which case the government would no longer be able to honor its debt obligations.
In summary, the dollar is weakening because other currencies, especially those of "commodity rich" countries provide an attractive hedge against inflation and because the unique "dual mandate" status of the Fed effectively forces it, in the context of the current environment, to be less proactive on the inflation front. Although the Fed will eventually have to tighten rates, there will be a lag in timing relative to the 18 other countries (mainly emerging) that have already embarked on hikes.
