The United States dollar has been declining at a 3 percent to 5 percent annual rate for approximately the past six years. The downward trend accelerated in mid 2007 spurred by the cut in US short-term interest rates and international concerns about the sub-prime mortgage crisis. After reaching historical trading lows against the Euro, the dollar exchange rate has steadied recently. However, the full consequences of a weak dollar on the US economy and markets create a ripple-like effect.

More declines are likely in 2008, but at a slower pace than prevailed for most of the last five years. Some economists project that the US dollar is now undervalued and will rise soon, but the current momentum is downward and will continue to be so into most of next year. A chief source of downward pressure comes from foreign central banks and investors as they work to reduce the volume of US dollars in their portfolios. Simply put, US imports flood foreign investors with payment dollars that they must absorb or reinvest. As the tide of dollars is traded, supply and demand laws take over, and the dollar surplus drives the “price” downward.

So, What is the Impact on Supply Chains?

The immediate and most obvious impact of dollar weakness is on purchase prices. We should expect price increases to offset currency value losses. Following that, there are secondary changes in spending patterns that result from volatile pricing moves.

In 2008, on average, prices of imported goods will rise 3 percent to 4 percent to directly adjust to the recent dollar depreciation. How quickly this inflation will occur depends on the particular market parameters (degrees of demand, supply and competition), but most of the price adjustment is expected to occur by mid 2008. Initially, foreign suppliers absorb the exchange loss to protect market share, but then margins are gradually restored over time. Domestically, the inflation forecast has not been bumped up significantly because US importers will absorb some of the exchange rate losses in an economy that is showing signs of slowing.

Some spend categories are more vulnerable to price increases, especially those areas that have vibrant international markets, such as construction materials and base metals. In 2008 and beyond, those materials could see price adjustments more quickly because of strong worldwide demand. A foreign supplier can insulate his revenue from currency losses by increasing sales to markets that offer more favorable conditions and de-emphasizing US activity.

World demand for the commodities used in construction and manufacturing, such as cement, steel and energy, is straining supply capacity. Therefore global conglomerate suppliers do not need to absorb as much of the exchange rate loss when they get paid in cheaper dollars than they expected. Metals, plastics and cement international product prices are already displaying this impact, but the prices of materials produced in the domestic US market are insulated from this effect. The decline in foreign supplier’s interest is sometimes first observed in reduced auction participation. In these occurrences, domestic suppliers may regain an advantage previously lost to foreign competition.

The US dollar has depreciated considerably against the Canadian dollar. The share of US manufactured goods coming from Canada has already begun to decline and is expected to slide further in 2008. In some cases, a corporate parent owns production facilities on both sides of the border, minimizing the difficulty of a sourcing change.

Exports Up, Imports Down

As you might imagine, the reverse of foreign impacts here is that US-made products are cheaper in foreign markets, boosting exports. While still at historic levels and with a general upward trend, the US goods and services trade balance has decreased its rate of expansion. According to the US Census Bureau, exported goods are up 13 percent while imported goods are up only 3 percent. The balance of trade surplus for services has jumped 35 percent. International sourcing has not yet fully adjusted to the decline of the US dollar that occurred in 2007, so the trade balances expected to decline further. Domestic suppliers will more aggressively go to market as they seek increased international sales.

An example of this effect can be seen in the US construction machinery industry. The Census Bureau reports that US purchases of machinery, both domestic and imported, have fallen by $1.5 billion per month since the peak in 2006, but 60 percent of this loss has been offset by a jump in US machinery exports and drop in US machinery imports.

Credit Costs More Now

A weaker dollar also has negative consequences for credit costs. So far, the US Federal Reserve Board has avoided having to raise interest rates to temper inflation and attract foreign capital. Economic forecasts are mixed for 2008, but some projections suggest that it may be necessary for the Federal Reserve to boost rates to steady inflation and finance the US trade deficit. In August 2007, there was a net withdrawal of foreign capital forth first time in nine years. That trend did not continue in September and October, but may reappear if economic measures weaken.

Last Thoughts

Economic forecasts and analyses by their very definition are complex, especially when contemplating macro measures like the exchange rate or trade deficit and its impact on your purchasing decisions. Still, these economic forces are very real and to be ignored at your own peril.

At its purest, the US dollar’s continued weakness against foreign currencies means imported goods and services cost more and exported goods and services go for less. For a supply chain, this can be a problem or an opportunity depending on your point of view. The trade deficit means large amounts of US capital are sent overseas, which spurs foreign production. A weaker dollar means US exports become more competitive, which could encourage increased domestic production. This may be good news for some US manufacturers, especially those threatened by foreign competitors. However, suppliers that rely on foreign parts or materials (as is increasingly likely) will see production costs rise as the dollar continues its fall. These costs will be passed on and inflation rates will rise.

From the proactive supply chain perspective, the weak dollar over such a long term produces both risks and possibly some previously overlooked stateside opportunities. Some international sourced deals may not be as advantageous or may present negotiation opportunities. Foreign currency trade impacts must be added to our supply chain thinking checklists and domestic manufacturers reconsidered. The falling dollar is not going to bring back the US industrial economy, but it may push some marginally profitable companies into the black again while providing freight relief at the same time.