Right now the dollar is being pummeled by traders, but its real future lies in the hands of the Federal Reserve. By Andrew C. Schneider, Associate Editor November 2, 2009 Reports of the dollar’s imminent demise are greatly exaggerated. Since its most recent peak in March of this year, the greenback has fallen about 10% on a trade-weighted basis. One-on-one against the euro, the buck is down 15% over the same period, but even by that measure, it remains well above its April 2008 record low of $1.60 to the euro.It would take a far more rapid sell-off to suggest a genuine currency crisis. “If the dollar’s decline got really out of hand, say 30% in a relatively short time, it would become very hard for the U.S. to roll over its debt at current interest rates,” says Niall Ferguson, a Harvard University professor who specializes in financial history. But such a rapid dollar fall is unlikely unless there’s a total loss of confidence in the U.S. economy and its financial markets. This might have been expected at the height of the financial crisis. In fact, one of the biggest surprises of the crisis was that investors flocked to the dollar as a safe haven. If anything, the dollar’s decline over the past seven months reflects traders’ confidence in a global recovery. With the federal funds rate still close to zero and investors regaining some appetite for risk, many are selling dollars to buy higher-earning foreign currencies. This process, known as the carry trade, was one of the factors that pushed the dollar down during the final years of the most recent boom. Advertisement “You’re seeing a pretty broad-based love affair with emerging market assets, including but not limited to equity markets,” says Philip Suttle, director of global macroeconomic analysis at the Institute of International Finance in Washington, D.C. The buck’s value won’t climb till the Federal Reserve hikes interest rates, probably not until mid-2010 at best. When that happens, though, the appreciation could be particularly sharp. When traders see that such a hike is imminent, many will start unwinding their positions in the carry trade. That has the potential to whipsaw those emerging market economies that have no or minimal currency controls. At present, their currencies are climbing rapidly against the dollar, making their exports less competitive. But investments now pouring into their economies could drain just as quickly when the dollar recovers. Even more worrisome is the prospect of such hot money fueling inflation and asset price bubbles, which could burst with devastating effect. Brazil, which suffered a currency crash in 1998-1999, has just slapped a 2% tax on capital inflows to cool such speculation.