Thursday, February 25, 2010

The U.S. Dollar in a deflationary environment

Most people would think that the dollar would fall in value when the Federal Reserve is printing money. There are two problems with that assumption the way I see it. First, In a deflationary environment, banks don't want to lend. The money that the federal reserve is printing is being held on Banks' balance sheets and is not getting out in to the economy. Simply put, there is very little velocity. Second, the money that is getting out into the economy (increase in the supply of dollars) is vastly overwhelmed by the volume of credit contraction (decrease in the supply of money and credit). The supply of and value of credit is contracting as debts are either being restructured (partial value loss in credit) or defaulted upon (total value loss in credit). That is just the supply side of things. The demand for Dollars is also going up as debtors are scrambling for dollars to pay off their debts. So, there are two forces causing an increase in the value of the dollar: The contraction in the supply of dollars, and the increase in the demand for dollars. From an investment prospective, instead of keeping their wealth in long term bonds, investors are keeping their wealth in short term T-bills and other safe cash equivalents, even plain old dollar bills. Thus, the demand should be for safe dollars rather than for exotic financial instruments and debts. The effect should be rising interest rates and a rising Dollar. Time will tell If I'm right. I'll post an update when new developments arrive.

Interest Rates in a Deflationary Environment

People Normally Associate Rising rates with Inflation (Since the Value of Dollars is going down, people expect to be compensated with a higher rate of return.)However, This chart displays how it is indeed possible (and I think likely in this environment) to have rising interest rates in a Deflationary environment. When the Demand for money and credit goes down, one would expect the price of money (Interest Rates)to go down as well. However in this case I think the supply of Credit (people willing to lend out) is contracting faster than the demand for money and credit, so the price (interest rate) goes up.