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Crescenzi: The Dollar's Drop Is Overdone

A major reason for the dollar's sharp plunge today is the notion that the Federal Reserve's expansion of its balance sheet will boost the supply of dollars and devalue the dollar. This would be true if banks were expanding the money supply through securities purchases, loans, and leases, but such is not the case: bank credit has been falling since March, the worse 6-month period in 50 years.

This means that the Fed's injection of money merely fills a gap. This reality is not enough, however, to alter perceptions about the Fed's actions, which will drive the performance of the dollar in the hours and days ahead. (For more about Fed actions, see video)

The longer-term outlook for the U.S. dollar therefore depends upon whether investors perceive the enlargement of the Fed's balance sheet to be temporary or permanent. Two relatively recent periods of rapid expansion of the Fed's balance sheet were seen as temporary and thus had no adverse impact on the value of the U.S. dollar: Y2K and 9/11. In both periods, the monetary base expanded sharply, before eventually falling back to trend.

We can't know whether foreign investors will see the enlargement of the Fed's balance sheet as likely to be temporary or permanent, but it is likely that it will be temporary, so this means that any dollar weakness that results from the idea that the Federal Reserve will be expanding the money supply too rapidly will likely reverse.

I again emphasize that the contraction in bank credit makes it obvious that there can't possibly be an excess supply of dollars in the financial system, only that there could be perceptions of such that drive market prices for a short time.

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Tony Crescenzi
Tony Crescenzi

Tony Crescenzi is the Chief Bond Market Strategist at Miller Tabak + Co., LLC where he advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of the forthcoming book, "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."Crescenzi is a contributor to RealMoney.com."