The U.S. dollar fell to its lowest point ever against the euro Wednesday as traders bet the Federal Reserve will soon cut the overnight bank loan rate. U.S. Treasury Secretary Henry Paulson also warned that volatility in financial markets won't relent any time soon. The news has Wall Street worried, but what does a depreciating dollar mean for U.S. consumers, businesses and the economy?
Here are some questions and answers.
Q: How does the dollar's fall against the euro and the British pound affect consumers?
A: For one, it makes it more expensive for Americans to travel and shop in Europe, said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn. At today's exchange rates, it takes $1.39 to buy one euro, up from $1.17 in November 2005. That means a 300-euro room at a Paris hotel has jumped to about $417 (or more, depending on where you changed your dollars into euros) from $351 back then. "Anyone who goes to London or Paris right now is going to feel like they're being gouged and regret booking the trip," Gilmore said.
Conversely, the depreciating dollar encourages travel to the U.S. by Europeans who gleefully find their money buys them cheaper accommodations and everything seems to be on sale.
Q: Is the dollar's decline bad for the economy?
A: Not necessarily. When the dollar loses value, U.S. manufacturers benefit as foreign trading partners buy up more of their goods. Construction and agricultural equipment maker Deere & Co. said last month that its third-quarter profit jumped 23 percent on strong international sales. Heavy equipment maker Caterpillar Inc. boosted its exports from approximately $9 billion in 2005 to $10.6 billion in 2006. Over half of Caterpillar's products made in the United States are exported.
That's why many currency traders think the Bush Administration is privately pleased by the dollar's decline, knowing that it turbocharges export sales. But as previous administrations discovered, you have to be careful what you ask for. Remember the backlash in the 1980s after Japanese used the soaring yen to buy up everything from Rockefeller Center to the Pebble Beach golf course? That could be a prelude for another crisis of confidence if overseas buyers with strong currrencies pick up the pace of their purchase of prime real estate and iconic major U.S. corporations.
In addition, Americans almost certainly will end up paying more for imported goods such as Mercedes and BMWs made in Germany, which is one of the 13 nations that use the euro as their currency. That reduces U.S. consumer spending power and also could trigger higher inflation.
Q: Why is foreign investment in the dollar important?
A: Foreign buyers have to first obtain dollars when they want to purchase assets like U.S. Treasury securities and stocks and bonds, and their money supports growth in those markets.
Much of foreign investment in the dollar originates from overseas central banks in the form of U.S. Treasury securities, which are safer investments than stocks and bonds. The U.S. Treasury in turn uses those investments to finance the federal deficit. If central banks and other foreign investors shy away from U.S. Treasury securities, the government will have to pay higher and higher rates at auctions at weekly auctions to find buyers for its bills, notes and bonds. And that would eventually push up borrowing costs for all Americans.
Currency traders anxiously await the Fed's Sept. 18 meeting for its decision on interest rates, which could further weaken the dollar. The expected quarter-point cut to 5 percent would still leave overnight rates above the European Central Bank's 4 percent peg. But by narrowing the gap, it could cut into traders' profits.
Currency traders make money by financing purchases of higher-yielding currencies like the dollar with lower-yielding currencies. They earn money on the assets backed by the higher U.S. interest rate, pay back the loan on the lower-yielding currency, and then pocket the difference.
Q: Will this affect my paycheck?
A: Yes, in the sense that a weaker dollar can't stretch as far to buy foreign-made products. "It reduces purchasing power by raising the cost of imported goods, and in some cases there may not be perfect substitutes, so consumers might end up paying higher prices," Gilmore said. In the long-term, workers could demand higher pay to compensate for that diminished purchasing power, straining businesses' resources, he said.
Falling purchasing power and rising prices force the Fed to balance its two major responsibilities: trying to maintain stable prices while promoting growth. Wall Street is hoping they focus on the latter, at least for now, crossing its fingers for a rate cut to jump-start the economy.