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Why a Falling Dollar Shouldn't Stoke Fears of Inflation

It seems that almost daily now I'm barraged by e-mails and calls asking about the "collapse" of the dollar. The rapid run up in the prices of precious metals, oil and many other commodities has fueled fears that the falling dollar will inevitably lead to rampant inflation. A simple look at history shows us that these fears are unfounded.

On December 11, 2000 the Euro was trading at around $0.88. By April 22, 2008, it had reached $1.60, meaning a rise in value by 82 percent relative to the U.S. dollar. If it were true that a collapsing currency causes inflation, then we should certainly have seen the evidence during this period. From December 2000 through April 2008, the CPI rose 2.9 percent, virtually identical to its 3 percent rate of increase since 1926.

The Euro is now trading at around $1.45, or still about 65 percent higher than its level on December 11, 2000, and inflation has been less than 2.5 percent since then.

And the Euro isn't the only currency the dollar has collapsed against. For example, on April 2, 2001 the Japanese yen was trading at about $0.0078. Today, it's trading at around $0.0124, a rise of almost 60 percent. Where's all the inflation we're supposed to see?

The same fears about inflation arise when budget deficits are discussed -- and we know how bad our deficit situation is. If budget deficits caused inflation, Japan would be experiencing hyperinflation as it has been running massive deficits for more than two decades now, as its debt-to-GDP ratio is about 200 percent, while ours is still a fraction of that (about 70 percent). Yet, for the past two decades, the Japanese have been struggling with the problems of deflation, not inflation.

The mistake investors make when thinking about the relationship between currencies (and budget deficits) and inflation is that they fail to understand what Milton Friedman famously pointed out: "Inflation is always and everywhere a monetary phenomenon." Falling currencies or budget deficits don't cause inflation. Large and persistent increases in prices are caused by excessive growth in the money supply. High inflation is always a monetary phenomenon, having nothing to do with currency valuation or budget deficits.

Here's another important bit of information. Despite all the noise from the doomsayers and the financial media about the rapid rate of growth of the money supply, the rate of growth of M2 (a broad measure of the money supply) for the 12 months April 2010 to April 2011 was just 4.9 percent. Going back a little further we see that for the two years from May 2009 through April 2011, seasonally adjusted M2 increased at an even slower rate of 3 percent. And going back three years, the rate of increase is under 5 percent.

The bottom line is this: Falling currencies don't cause inflation. And neither do budget deficits. As Friedman said, inflation is purely a monetary phenomenon.

And finally, for those concerned that the Federal Reserve will allow money supply growth to become excessive (thus causing inflation), the best hedges of that risk are in order:

  • TIPS (by far the best and only pure hedge)
  • Commodities (in the form of a broad-based commodities index)
  • Short-term nominal bonds
Gold and other precious metals aren't good hedges of inflation as their correlations to inflation are about zero.

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