This article responds to a request to explain the recent strength in the dollar, by which I think was meant the dollar index. The following discussion explains some of the longer term factors that I think are important. This provides perspective on the recent movement. After that, the discussion turns to the question of gold prices.
A long-term view of the dollar index is here. The dollar index is not the dollar against gold. It is the dollar against other major currencies like the Euro, British pound, and yen. The current period of rally in the dollar (index) is from 74.82 to 82.46 today. The index had gone to a new long-term low and stabilized there for 5 months (March-July of 2008) before starting the current rally.
The dollar was strong in the early 1980s, as U.S. growth improved. However, the national debt rose sharply (it doubled) from 1980 to 1985. The 1985 Plaza Accord made matters worse. Despite the debt rise, the U.S. agreed to a weaker dollar. It also agreed to cut its budget deficit, which it didn't. By 1991, the debt had again doubled! The dollar fell sharply, from 164.72 to the 80s area where it stabilized. This was a 50% devaluation in terms of other currencies.
Increased U.S. debt is a factor that undermines the dollar. Better U.S. growth helps the dollar. The reason for this is that the dollar's value depends on its backing on the Federal Reserve's balance sheet. The backing consists of two main items: gold and U.S. Treasury debt securities. The backing of the U.S. bonds is the tax collections of the federal government. As the debt rises, all else equal, the greater debt must be serviced by the same amount of taxes. This reduces the debt's quality. The backing of the dollar worsens and it declines. The Fed could maintain the dollar's value by selling bonds, but it chooses not to do that because that tends to impact the economy negatively. As growth increases, all else equal, the dollar gains strength because the tax revenues improve and the dollar's bond backing improves in quality. The dollar index is also influenced by what the other countries are experiencing for their deficits and growth rates.
The dollar index mounted a strong rally starting in 1995 and through mid-2001. The debt rise in those years was "only" from 5 trillion to 6 trillion, which was at a far lower rate than when it was doubling every 5 years. The U.S. government ran a surplus at times and was able to retire some debt. The dollar's backing thus improved and so did its value. Meanwhile, growth was robust and that helped too.
The recession in 2001-2002 ended this rosy picture. Tax revenues fell as growth fell. Since government spending remained high, more bonds were issued. The growth of government debt accelerated sharply. The Bush administration added to this of its own accord by big rises in deficit spending. The dollar started falling in mid-2001 and really has not had a rally yet that clearly indicates a change in that trend.
The latest little rally is against some other currencies in the index whose economies have taken an even greater turn for the worse (except the strong yen). That is probably why the dollar index has shown some strength. As the U.S. enters another recession, which looks to be deep and prolonged, deficits will mount even more as growth slows. This is bad news for the dollar. The news will be bad for some other countries too that are in the dollar index, and the index need not decline if those other countries face even greater difficulties than the U.S..
The dollar index will strengthen if the next administration raises taxes and holds spending in line, as the Clinton administration did. An end to the Iraq war spending would help the dollar.
The dollar versus gold is another matter. They have to move inversely to one another. The course of gold prices tells that story. It is not all that easy to interpret the movements of gold. I analyzed gold versus money supplies in an article "$10,000 Gold" and an article "Gold at $635: Buy, Sell, or Hold?" The latter estimated a gold value of $656 to $1,099 based on M1 money supply and the monetary base. Using M2, the estimate was $3,100. The theory there, such as it was, was that gold more or less appreciated as the Fed increased the money supply per capita.
But it is obvious that gold's appreciation has been anything but smooth or even! See here. Gold had a tremendous rise in 1980 and then languished with ups and downs until mid-2001. The price rise of gold in 1980 was too far too fast in terms of the currency depreciations at that time. That is one reason why it stood still for so many years thereafter, albeit with some large interim fluctuations.
Since 2001, gold has risen as the dollar index has fallen, but it has risen more sharply because the other currencies have also fallen in terms of gold. This appreciation in gold coincides with a world-wide inflation of paper currencies. Gold caught up to the inflation, so to speak. As long as these central bank currencies continue to be manufactured without solid backing, either gold or tax revenues, gold will continue to have a long-term upward trend. The volatility in gold prices will, in all likelihood, also continue, and that makes it hard to forecast the shorter-term movements with a factor like money supply. Note that the big increases of recent days have not pushed gold to new highs. In the longer run, however, we can be quite sure that gold will move higher if nothing is done to improve the backing of the world’s central bank currencies.
