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As the global economy continues to improve, the new worry in the markets is that the US could face a dollar crisis. Although the dollar will likely weaken further in the months ahead, but a crisis is unlikely. This debate has been poorly framed in the press and here try to put it in perspective.

While the dollar has weakened, the drop is not a particularly big by historic standards:

�� The drop has not fully retraced the safe-haven rally of the last year
�� On a 12-month basis the dollar is essentially flat against most currencies
�� Zeroing in on the last three months: since 1990 there have been 15 periods where the three month drop was larger
�� Looking over the full history of the dollar: the real broad index is now modestly below its historic average

Not only is the dollar drop modest, it has not created the collateral damage that comes with a crisis. A weakening of the dollar in and of itself is not a big deal. On the margin it shifts spending to the US, hurting growth outside the US and helping US growth. It also on the margin boosts inflation in the US relative to its trading partners. However, these effects are small: typical model simulations suggest a 10% drop in the trade weighted dollar adds a couple tenths to US growth and inflation. In the current environment, the weak dollar adds to the case for a weaker recovery in Europe than in the US.

Pundits seem to warn of a dollar crisis every other year, but there have been only two recent crises associated with a weak dollar. First, when the dollar plunged in the late 1980s it put upward pressure on US bond yields and may have helped trigger the stock market crash of 1987. Second, in the summer of 2008, the weakness in the dollar helped inflate a commodity bubble.

Will history repeat itself? Today, there are no hints of pressure on the Treasury market or the US stock market. Indeed, the both markets have rallied in recent weeks. On the other hand, there are some signs of pressure on commodity prices. Gold has moved above $1000/oz. A much bigger concern is oil because it is such a
big driver of headline inflation. Oil prices have crept up a little in recent weeks.