First off, we are talking about the modern notion of inflation, rising prices as expressed in the Consumer Price Index (CPI). Historically, inflation had been considered an increase in money supply. Economists have decided to blur the term to have a more accurate measure of inflation. When economists embraced what some consider a conspiracy to shortchange retirees entitled to inflation-indexed social security benefits, it may have merely been an attempt by economists to please policy makers, so that their alien identity would not be revealed.

What conspiracy and alien theories have in common is that they imply its a question of personnel rather than the system. If theres one thing we have learned in our discussions with policy makers, including those whose policies we disagree with, it is that they generally work with the best of intentions as in, the road to hell is paved with good intentions.

When Federal Reserve (Fed) Chair Ben Bernanke tells us a weak dollar is not inflationary, he truly means it. And he is right. But possibly also very wrong. As a scholar, his view is based on research conducted at the Fed. Research refers to a study of the past, with the argument that the past may be the best we can go by in assessing the future. But given that our current fiat monetary system has only been in place since Nixon removed the last link to the gold standard in 1971, one needs to consider that we have hardly had enough economic cycles to truly understand all levers that drive inflation and the U.S. dollar. In a world inundated with data, economists are eager to find patterns to extrapolate. Not surprisingly, I had to endure presentations by very smart Ph.D.s in the years leading up to the financial crisis who argued that housing prices would never decline: just look at the data! It never happens, not in the U.S. The missing piece in the analysis was common sense; but as we all know, it wasnt just a few that were caught in this trap.

The reason Bernanke is right is because in the past, indeed, a weaker dollar has not necessarily been inflationary. Most notably, the U.S. dollar index almost halved between February and December of 1987. The CPI, however, increased by a mere 4.4%. The main reason why, historically, a weaker dollar may not have been particularly inflationary, is that foreign exporters tended to absorb what amounts to a higher cost of doing business in a weak dollar environment. Because of competition, foreign exporters tend to be limited to two choices: reduce margins as exporting to the U.S. becomes less profitable, or stop selling into the U.S. market if it is no longer profitable.

There are numerous ways to manage currency risk: they include hedging in the forward currency markets, but also include moving production to lower cost countries or to the country where the customer is located. Lower cost countries tend to be the preferred destination for low-end consumer goods: Vietnam has seen a lot of investment as the cost of doing business in China has risen. However, for more value-added goods, producing closer to the consumer often makes sense: Toyota and BMW are two of the higher profile examples that have built plants inside the U.S. Active management of foreign exchange rates can buffer many risks, leading to a mitigated impact on consumer prices. Having said that, the management of foreign exchange risk can be an art as much as a science, and mistakes are made. Chinese businesses love fixed exchange rates because it is one less item to worry about; conducting business in a world with free floating exchange rates is a skill learned over time, a key reason why Chinese policy makers are rather slow to allow the yuan to appreciate.