Currency May Turn Deflationary

Interesting editorial in the WSJ about a rising dollar driving deflation. The editorial highlights recent comments by Nobel Laureate Robert Mundell, who predicts a strengthening dollar once QE2 ends. Mr Mundell points to two examples that produced a strengthening dollar:

(1) The summer of 2008 when the Fed paused in lowering the fed funds rates and the dollar appreciated 30% in a few weeks, and

(2) November 2009 with the end of QE1 that saw a strengthening dollar relative to the Euro.

With the end of QE2, the prediction is that the dollar strengthens against the Euro unless the government acts aggressively, resulting in deflationary pressures as imports become relatively cheaper.

Currency deflation would add additional downward pressures to the outlook for prices. I believe there may be growing downward pressure on prices from fiat actions (government austerity and tightening of monetary policy as QE2 ends), commodities if prices continue to pull in, goods and services due to excess supply and a leveraged consumer,  tangible assets from declining house prices, and potentially wages due to high employment and employers seeking out lower cost labor. If financial markets roll-over, as I expect them to, this would provide one more deflationary weight on prices.

Inflation dominates the headlines today, but I expect deflation to dominate the markets through the end of the year.