The Dollar and Its Rally Need Real Support - TheStreet

Even with the recent uptick in the value of the U.S. dollar, the world's reserve currency remains dramatically weaker than it was at the start of this decade, and it's likely to stay that way, if it doesn't sink even further.

The greenback has lost about a quarter of its value over the last half-decade, and it's down 15% since the beginning of 2007, according to a New York Board of Trade U.S. dollar index that tracks its value against a basket of foreign currencies. While White House officials have stuck to their empty mantra in support of a "strong dollar policy," they have repeated that slogan much less frequently this year than they have in the past.

"The U.S. Treasury puts itself in an awkward position when it repeats its belief that a strong dollar is in the best interest of the country at a time when the dollar is struggling with record lows against the euro and other foreign currencies," says Michael Woolfolk, senior currency strategist with Bank of New York Mellon.

Economists point to the benefits that a weaker dollar will have in easing the trade deficit that the U.S. has piled on for decades. Meanwhile, workers and consumers are watching the value of their wages and their savings shrink, while their cost of living goes up. Skeptics say the dollar's days as the world's reserve currency could be numbered, and that's a prospect that would have profound consequences for the U.S. economy and its influence around the world.

Jeffrey Frankel, professor of economics at Harvard's Kennedy School of Government, published a study last year with his colleague, Mennzie Chin, predicting that the euro will begin to displace the dollar as the leading international currency by 2022. They pointed to the fate of the British pound, which lost the top spot on the totem pole of world currencies during World War II, as a guide.

"As some wonder whether the United States might now have embarked on a path of 'imperial over-reach,' following the British Empire down a road of widening budget deficits and overly ambitious military adventures in the Muslim world, the fate of the pound is perhaps a useful caution," wrote Frankel and Chin in their report.

Recently, the authors revised their estimated date for the "tipping point" of the dollar's decline to 2015 as the U.S. housing and credit crisis brought its value to record lows.

"Euroland, as measured by current exchange rates, has become a bigger economy than the U.S. within the last six months," says Frankel in explaining the change. "That's a consequence of the depreciation of the dollar."

Multinational companies, from

General Electric

(GE) - Get Report

to

Google

(GOOG) - Get Report

, have shown far better operating results in overseas markets than in the U.S. Investors, in turn, have increasingly shifted their focus toward opportunities overseas.

In this climate, it's hard to find any substantive policy measures in place that justify the Bush Administration's strategy of communicating support of a strong dollar. The government's main lever for influencing the value of the currency is the monetary policies of the

Federal Reserve

. Since the outbreak of the credit crisis last summer, the central bank has slashed its short-term interest rate target by 325 basis points, which means it has been expanding the money supply and devaluing the dollar.

On the fiscal side, tax receipts are shrinking amid a slowing economy while spending shows no sign of abatement between two wars raging in the Middle East, a fiscal stimulus package for consumers and rumblings of a bailout for mortgage borrowers facing foreclosure. Government deficits at the federal and state levels are headed for big increases.

Although the U.S. trade deficit has been reduced -- it was measured at $58.2 billion in March.

The U.S. Treasury used to intervene in currency markets on occasion to influence the value of the dollar by buying and selling various currencies. While various foreign governments regularly engage in such intervention, the U.S. has abandoned the practice completely in this decade.

"The strong dollar policy has lost all meaning," says Frankel. "The only reason for the mantra from the White House now is that if they deviate from it in the slightest way, then it gets written up as a story and the markets have a big reaction to it."

Given the current fragility in the world's financial system, U.S. officials want to avoid roiling currency markets. While the dollar's decline does offer some relief to U.S. businesses in the global market, a rapid fall-off in its value could spark a dumping of dollar-denominated assets by foreign investors that have long financed the nation's twin deficits. The specter of such a disastrous event was raised back in March when

Bear Stearns

( BSC), the fifth-largest U.S. investment bank, teetered on the brink of bankruptcy before the Fed orchestrated its fire-sale to

JPMorgan Chase

(JPM) - Get Report

.

"The U.S. has to be careful about embracing a weak dollar," says Woolfolk. "Extreme weakness would be a negative for confidence and foreign investment into this country. It also stimulates inflation and makes monetary policy decision-making far more difficult. If the pace of weakness accelerated, the marginal inflation impact could be very detrimental."

Woolfolk says the dollar remains stable and he predicts it will maintain its stature in global markets, although it may wind up sharing the stage over time with the euro and the Chinese yuan on a regional basis. In the near term, he says the dollar could be close to making a sustained bottom.

"We've seen a period of relative stability since the Bear Stearns debacle," says Woolfolk. "After more days and weeks go by from that event without further disorderly conditions arising in the financial sector, the closer we are to a bottom."

In the last month, the NYBOT U.S. dollar index has rallied by about 2.5% amid signs that the Fed will stop lowering interest rates in the months ahead and possibly even hike rates before the end of the year. That forecast largely rests on a recovery for the U.S. economy in the second-half of the year, a prospect that many economists say is unlikely given continued declines in the U.S. housing market.

"We expect the European Central Bank to tilt towards an easing bias, and we expect the Bank of England to signal the possibility of rate cuts there, so that will push the dollar higher in the near term," says David Watt, senior currency strategist with RBC Capital Markets. "The longer-term outlook for the dollar is more complicated because we're simply not sure yet that the economy has fully offset the downside risks from the mortgage crisis and the follow-on risks to U.S. consumer spending."