Jon Kyl, March 17, 2008

At $110.70 a barrel, oil prices hit another record high on March 13, and the weakness of the American dollar has a lot to do with it.

Often the increase in oil prices can be attributed to political turmoil in the Middle East or a significant supply issue (as occurred after Hurricane Katrina). While these are factors today, there is another reason you could see an increase in the price at the pump.

Since January 2007, while oil prices have nearly doubled, the American dollar’s value has decreased by approximately 12 percent. As the economy has slowed, the Federal Reserve has dropped the Federal Funds rate numerous times over the past year -- a total reduction of 2.25 percentage points since January 2007. Dropping the interest rate is meant to stimulate the U.S economy, but it also weakens the dollar.

The American dollar is the currency used by the Organization of the Petroleum Exporting Countries (OPEC), the conglomerate of oil producing nations that sets global oil prices. Thus, any fluctuations in the value of our dollar are reflected in the price of oil.

As our dollar falls in value relative to the euro, yen, or price of gold, the price of oil goes up. Since oil is priced using the American dollar, what Americans pay for oil will increase to compensate for this change. At the same time, however, other nations are shielded from the same oil price increase because their own currencies are more valuable than the dollar. European and Asian countries (among others) are importing their oil for significantly less than what Americans are paying. Europeans pay just 66 euros for a barrel of oil while Americans pay more than $110. Returning the U.S. to a "strong dollar policy" would greatly reduce the price U.S. consumers pay for oil.

Confidence in the value of the U.S dollar is also vital to American financial competitiveness. A weak dollar makes investment in foreign markets more attractive, particularly for those who seek to diversify their portfolios as our economy slows. Further dollar weakness could precipitate a dramatic shift of money from domestic to foreign markets.

The key idea to understand here is that the value of our American dollar is an important consideration to the investor and consumer confidence. Without this confidence, our economy will have a difficult time avoiding recession.

So these are several reasons why it is in our nation’s best interest to support a stronger U.S. dollar. Economist David Malpass wrote in a recent Wall Street Journal op-ed, "A strong, stable currency is itself one of a country’s most valuable fundamentals, not a byproduct of other fundamentals. Our fundamentals haven’t been nearly as bad as the dollar’s seven year slide. More likely, the weak dollar trend is itself a bad economic fundamental, masking health elsewhere."

There are two things that can be done to better the dollar. First, the Federal Reserve should switch its focus from maintaining economic stability to fighting inflation. In periods of slower economic growth the Federal Reserve traditionally responds by reducing short-term interest rates, but that can exacerbate inflation, which has increased substantially -- growing at 4.0 percent in February from the same time a year ago.

Note that while the dollar has fallen, the euro remains relatively strong because the European Central Bank (ECB) has refrained from lowering interest rates due to their concerns about global inflation. The Federal Reserve needs to follow the ECB’s lead and resist the political pressure to cut interest rates further in order to stabilize the value of the dollar. The second thing would be for Congress to begin to make our current, relatively low, tax rates permanent.

Our currency is the foundation for our economy; without a strong dollar our economy will not be able to achieve the stability that is necessary to control oil prices or the economy.

Senator Jon Kyl, a Republican, represents Arizona in the U.S. Senate. He serves on the Senate Judiciary Committee, the Finance Committee, and the Energy and Natural Resources Committee.