Central banks would normally fight such risks to their nation’s gross domestic product by lowering interest rates to encourage demand, as the Federal Reserve, the Bank of Canada and the Bank of England have all demonstrated recently. The Fed has lowered the U.S. interbank lending rate by 3.25% since September, ferociously fighting the specter of recession, followed by the BoC (1.5%) and the BoE (0.5%) beginning in December as the slowdown snuck across their borders.

Because foreign currency exchange terms are heavily influenced by interest rates, when a nation’s official rate is lowered, the value of the currency declines as well. The weakening U.S. dollar (USD in forex cant), which has been sliding in value since April 2002, raised the cost of imports, including crude oil, and therefore discouraged hauling goods into the country. At the same time, the record low exchange rate reduced the cost of U.S. exports, which was good for the U.S. economy but not for its trading partners who increasingly find their own domestic production competing with goods made in the U.S.A. in an international role reversal.

Weakening Dollar and Soaring Prices

This global slowdown is being fueled by soaring inflation biting into consumer and corporate spending, lowering the level of discretionary funds in countries ranging from China to Germany. In Germany, producers’ prices rose 8.1% from May 2007 to May 2008, while in China, retail prices shot up 7.7% in one month. Pork alone rose 48%.

Most of these higher prices can be traced back to higher commodities prices with crude and fuel oils being the major culprits because they affect production costs. The reasons for crude oil doubling in price within the last twelve months is an article in itself, but the boost given by USD weakness against other major currencies—and remember, most commodities are priced in U.S. dollars—is estimated at around $25 per barrel.

So let’s put this in perspective. Global inflation is high because commodities prices are high. High commodities prices are caused in part by USD weakness. Ergo, strengthen the USD and watch commodities prices fall and inflation recede worldwide.

If only it were that simple.

The value of any nation’s currency, relative to those of other nations, is based on many factors—economic growth and prospects, interest rates, balance of trade, governmental accounting ledgers and so on—all of which take time to make their influence felt. Although U.S. exports contributed 0.34% to first quarter economic growth in 2008, nobody knew that until May 29 when the U.S. Department of Commerce released the data, and the resulting shift between the USD and the euro, for example, although monumental in forex terms, only strengthened the dollar by two cents.

Speaking to the Economy

So the USD isn’t going to become Popeye overnight, and the original global dilemma remains. Central bankers can’t raise interest rates to fight inflation because they’ll cut into GDP growth which is already balanced on a razor’s edge between creeping progress and outright recession. They can’t lower interest rates to encourage growth because inflation will balloon out of control. What, then, can they do?

They can talk.

Around the globe, politicians and central bankers are rattling verbal sabers. Most practiced at this art is the European Central Bank’s president, Jean-Claude Trichet, who has a series of “code phrases” that are inserted in his speeches when he and his multinational banking cadre are considering changing rates. Let the financial district hear him mention “heightened alertness” regarding inflation, a phrase signaling an interest rate hike, and the euro zooms up like a rocket.

So when France’s Finance Minister, Christine Lagarde, commented that the USD’s gains against the euro were “very satisfying” and when Russia’s Finance Minister spoke of the need for a stronger dollar, they’re fighting against currency exchange rates for their citizens’ purchasing power.

Let’s hope the global economy pays attention.