A Falling Dollar Doesn't Mean Rising Inflation

(MoneyWatch)  As you may know, one of my favorite hobbies is to point out how often the conventional wisdom on investing is wrong. Today, we'll show that the conventional wisdom that a falling dollar inevitably leads to higher inflation is as wrong as the Earth is flat. To prove this point we will use my favorite tool, Mr. Peabody's WABAC machine. (Rocky and Bullwinkle was my favorite show growing up.)

At the end of October 2000, the Euro traded at around $0.84. By April 2008, the Euro had risen to just short of $1.60, an incredible 90 percent increase against the dollar. If a falling dollar inevitably caused high inflation, we certainly should have seen it show up. However, the CPI rose just 2.85 percent during this period, or less than the historical average of 3 percent.

While the dollar has recovered somewhat from its lows of 2008 -- the Euro is currently trading at about $1.41 -- if we extend the time frame through June 2009, the inflation rate since November 2000 was just 2.5 percent. We have now had almost nine years of a sharply falling dollar, but where exactly is the inflation that a falling dollar is supposed to inevitably cause?

The problem with the conventional wisdom is that a falling dollar does not cause inflation. The relationship is backwards. High inflation can cause a falling dollar, assuming our inflation rate is higher than that of our competitors. Inflation is not a currency phenomenon; it is a monetary phenomenon.

As this example demonstrates, much of the conventional wisdom about investing is wrong. And basing investment strategies on false premises can cause major problems. You would be wise to remember Bentley's Second Law of Economics: The only thing more dangerous than an economist is an amateur economist!