Why the US dollar will eventually recover

For Middle East businessmen nervously eyeing the direction of the US dollar, these are tricky times.

The greenback has fallen sharply against the euro which is the currency used to buy the majority of imports to the region, squeezing margins and putting upward pressure on prices.

But any economic analyst will point to a chart of the US dollar over the years which has moved up and down in long waves. So a weak dollar is not a permanent state of affairs. What will shift it back up again?

Interest rates hold the key. In the past six dollar cycles we have seen four aggressive interest rate hikes, and two modest ones of around 1.5%. How high and how fast the Fed will decide to raise interest rates depends on the speed of the US economic recovery.

A fast recovery will start to cause inflation and require a big hike; a modest recovery will need less aggressive monetary tightening, unless inflation also takes off. Now which is it to be?

Here is where we have to be more cautious in analysis, for black and white it is not. Rising oil and commodity prices point to a strong upturn in US inflation towards the end of the year. That would mean rates needed to go up aggressively, and once the US Presidential Election is over there will be no politics to prevent it.

The US economy would then go into a recession in 2005, but the US dollar would start to recover against other major currencies. A recession would permanently rebalance the US twin deficits, albeit at the cost of lost output and growth, and bankrupt companies and investors.

An alternative scenario is that US economic growth is less strong than anticipated. This will tend towards a moderate tightening of interest rates to support the US dollar later in the year, and cause further US dollar weakness in the second half of 2004.

Some argue that such US dollar weakness is the last lever that the Washington mafia can pull to get George W. Bush re-elected. But given the time-lag involved between a weak dollar and economic expansion, it might be that a stronger dollar will start to emerge sooner rather than later.

Could the European Central Bank unwittingly help to get George W. Bush elected? It is not beyond the realms of possibility if the ECB was to decide to lower its own interest rates next week, or in the near future.

A strong dollar would look good on election day, so long as the economic expansion caused by the weaker dollar was still in place.

In truth Middle East business should be careful to hedge its bets on the US dollar, and that is why gold is so strong. Anyone who offers a definite opinion on where the currency is going in the short term is as likely to be wrong as right.

However, one thing is for sure, the US currency will recover in value over the next year or two, even if it takes high interest rates and a US recession to achieve it.

At a certain point the market will takeover the determination of interest rates and ensure that the dollar recovers, and even the Fed can't buck the market for long.