The US and world economy is going through a difficult period. The fragile nature of the economic recovery has led to wrangling over exchange rates, with much focus being placed on the Fed's decision to pursue QE2 - and thereby reduce the value of the dollar.
By pursuing Quantitative Easing, the Federal Reserve is increasing the supply of dollars and thereby weakening the value of the US dollar against other countries. Some economists like J.Stiglitz are critical of this decision. Others fear that this decision to increase money supply in US will lead to inflation and a further fall in the value of the dollar.
The dollar has already fallen as markets anticipate the impact of the QE2 and the threat of future inflation which weakens the dollar.
I feel the threat of US inflation has been overstated. The US does not face the prospect of runaway inflation, but, faces an inflation rate below the target of 2% and the potential for deflation because of spare capacity and unemployment in the economy. By pursuing a relatively modest policy of Quantitative Easing, the Fed is implicitly trying to maintain its inflation target of 2%. This is nothing different to what it has done in the past. In ordinary circumstances, the Fed's job is to prevent inflation from exceeding the target of 2%, currently its job is to prevent inflation from falling under 2%.
Why is Dollar Falling if Fed is Targetting Usual Inflation Target of 2%?
Part of the reason is that other blocks like Japan and the EU seem less keen on targeting modest inflation target. The ECB seem more willing to put up with disinflation than go down a road of quantitative easing. Therefore, the dollar has looked relatively unattractive compared to countries who aren't pursuing quantitative easing
US Dollar to Euro.
On the one hand the ECB is unlikely to follow the Fed in pursuing Q.E. but, the EU faces a string of sovereign debt problems. Despite harsh austerity measures, Ireland seems to be following Greece in having unsustainably high bond yields. This renewed fear over solvency in the EU, could lead to a much weaker Euro, and make the US policy of Q.E. look mild compared to risk of default in EU.
At 0.7 Euro to 1 Dollar, I think there is a greater fear of a weak Euro and feel the Dollar may actually rise against Euro in 2011.
Forecast for Dollar
At the moment all the focus is on Q.E. and potential impact of inflation. However, if the US were able to really target higher inflation and cause economic growth, this in itself would cause dollar to rally. Any sign of renewed economic growth would raise prospects of higher interest rates and this would increase the value of the dollar. However, I feel that the US recovery will be too weak to see a return to growth and higher interest rates are hard to envisage in current climate.
Dollar to Pound
Recent months have seen a rise in the value of the Pound compared to the US Dollar. (1.4 US Dollars to £1) has changed to $1.6 to £1. This is related to the plans to reduce the UK budget deficit and fears over Q.E. in US. The UK has recently held back from more Q.E. as the recovery is stronger than expected. In 2011, the UK growth may appear more fragile as spending cuts bite, this may leave the UK economy in a similar position to the US. I would expect the dollar to remain around $1.5 to £1 throughout 2011.