Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar (Hussman)

This article is a guest contribution by John P. Hussman, Ph.D., Hussman Funds.

A week ago, the Federal Reserve initiated a new program of "quantitative easing" (QE), with the Fed purchasing U.S. Treasury securities and paying for those securities by creating billions of dollars in new monetary base. Treasury bond prices surged on the action. With the U.S. economy predictably weakening, this second round of quantitative easing appears likely to continue. Unfortunately, the unintended side effect of this policy shift is likely to be an abrupt collapse in the foreign exchange value of the U.S. dollar.

How exchange rates are determined - a primer

To understand how currencies fluctuate, it's helpful to understand two forms of "parity" that operate in the foreign exchange markets.

1) Purchasing Power Parity (PPP): This describes the tendency for long-term exchange rate movements to reflect long-term changes in relative price levels between countries. Suppose for simplicity that a given basket of goods costs $10 in the U.S., and costs FC40 in some other country (where FC is simply a unit of foreign currency). If the goods are identical and can be transported costlessly without any barriers, one would expect that $10 = FC40, or that $1 = FC4. So the exchange rate would satisfy purchasing power parity if one dollar traded for 4 units of foreign currency.

Suppose the foreign country is highly inflationary, so that the price of that basket of goods increases to FC60, while the U.S. experiences no corresponding inflation. PPP suggests that the exchange rate should track the relative price levels between the two countries, resulting in a new exchange rate of $1 = FC6. This would be a "strengthening" or "appreciation" in the dollar, since each dollar would command a greater amount of foreign currency. Conversely, this would be a "weakening" or "depreciation" in the foreign currency, since each unit of FC would command fewer dollars.

More generally, goods and services are not identical across countries and cannot be moved costlessly, so PPP is only a long-term tendency, and is not enforced at every point in time. Still, there is a strong tendency for exchange rate movements, in the long run, to reflect relative inflation rates of inflation between countries. Countries with high rates of inflation tend to depreciate over time, relative to countries with lower rates of inflation, and this depreciation is in nearly direct proportion to the relative changes in price levels (particularly when one uses price indices of tradeable goods).

2) Interest Rate Parity: This describes the tendency for exchange rates to move in a way that offsets expected differences in interest rate returns. Suppose that interest rates in the U.S. are 2%, and interest rates in the foreign country are 5%. If the exchange rate was expected to remain perfectly constant, and there were no barriers to capital movements, investors would have a strong tendency to buy the foreign currency in order to earn the higher interest rate. Of course, the exchange rate would not remain constant, as investors would tend to bid up the foreign currency. In fact, there would be a tendency to bid up the foreign currency until it was sufficiently elevated today that a 3% annual depreciation would be expected in the future. At that point investors would be indifferent, since the 2% interest rate available in the U.S. would be equivalent to the 5% interest - 3% depreciation expected in the foreign currency. From a foreigners perspective, the 5% interest rate available in that country would be equivalent to the 2% interest + 3% appreciation expected in the U.S. dollar.