Financial market economics can be very complex involving many correlations between differing financial products, economic data, and differing national interest rate levels and economic performances.  Layer over that the complexities of the foreign exchange market and it becomes difficult for the outside observer to connect the dots between the value of the US dollar at any given moment, rising commodity prices, stagnant wages, high unemployment, and the reality of paying more for the gas in our cars and the food on our shelves.

There is a distinction that can be made between the external value of the US dollar and how much the dollars in our pocket, earned from expending our own labor, can buy at the retail purchase point.

While there is unquestionably a long-run correlation between the value of the US dollar on the foreign exchange market and our domestic inflation rate, the ultimate price impacts are dependent on the degree to which the US economy is dependent on international trade generally, and imports priced in another currency more specifically.  For the United States our international exposure, while at near historic levels (imports of goods represent nearly 13% of total US yearly output), is still relatively low.  Moreover, key strategic imports we are dependent on are priced in US dollars, most notably crude oil.

In a floating exchange rate system, as the US is part of (China is not), the exchange rate is the transmission mechanism that motivates trade patterns and balances.  Elevated and sustained
trade deficits are corrected through a weakening currency by causing a substitution effect from imported goods to domestic goods.  Elevated and sustained trade surpluses are corrected through a strengthening currency by causing a substitution effect from domestic goods to imported goods.  Of course, poor trade policy and fixed exhcange rate countries like China skew this mechanism for balancing trade to some extent.

While the US suffers a hurtful imbalance of trade, with China and Asia generally having come to dominate whole consumer goods segments, significant portions of dollars spent by US residents still go to domestic purchases.  To the extent an American consumer is negatively impacted by the external value of the dollar it relates in part to the individual consumption choices of Americans.  If you like foreign cars, lots of electronics and gadgets, imported food products and the like, then your own personal inflation index will be meaningfully dependent on the external value of the US dollar.  If, on the other hand, you are someone who always tries to buy American, who doesn’t require food products from another country, then your own personal inflation index will be meaningfully less dependent on the external value of the US dollar.

A price rise in a given good, especially when it comes to food and energy, hits the pocket directly.  Americans today are feeling the pinch.  It’s understandable there are anxieties and semantic differences being used to describe a price rise, inflation, purchasing power, the value of the dollar.  Inflated prices for some goods we need rather than want is not a welcome outcome.  It implies reduced purchasing power:  getting less now for the same dollars you spent at a time in the past.

The rise in the prices of food and energy has more to do with speculative trading/investing than real supply and demand re-balancing, or the value of the US dollar against the Mexican Peso.  We saw evidence of this yesterday and today in the sharp sell off in commodities across the board (real end user demand didn’t change in the past 48 hours).  Since late 2001 the US dollar has generally been on a weakening trend with a whole lot of volatility along the way.  This has largely been related to low domestic interest rates, though also to ever increasing trade and budget deficits.  Algorithmic trading has come to dominate foreign exchange trading and with that comes a focus on correlations and the dismissal of typical fundamental analysis creating price movements that often times appear counter-intuitive.  Until we get our own house in order, and to the extent the rest of the world remains reasonably stable, we should expect ongoing weakness.

Want to avoid imported inflation, buy American produced goods with the fewest foreign inputs.

There is a giant caveat here:  this analysis assumes domestic producers don’t automatically match import price rises seeking profit gains through price, but rather go after market share and increase profits through volume.

The purchasing power of the US dollar domestically is often times a separate discussion from the value of the US dollar externally.