Chairman Bernanke's comments on the US dollar yesterday reflected a change in heart on the Fed's position on the US dollar. To print out the article, click on the PDF attachment at the bottom of the report.
Forex Analysis: The Fed's Change of Heart on the Dollar
Today, Fed Chairman, Ben Bernanke had a change of heart on the value of the dollar. In his comments at an economic conference in Barcelona Spain, the chairman said the following:
"In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets. The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation. We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of erosion in longer-term inflation expectations.
" He continues, "Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.”
This direct and detailed statement on the desire to maintain a strong(er) dollar by the Fed chief signals a shift in policy by the Fed as it continues its fight through the turmoil that has plagued the financial markets and the economy of the United States. It is our opinion that the change in heart on the dollar is the next step in the Fed and Treasuries plan for the healing of the United States economy and therefore should be taken seriously. Whether this phase was planned or reflects more a reaction to the developments that have transpired as they maintained a weak dollar policy will be debated for some time to come. Nevertheless, the key point is the Fed, in tandem with the US Treasury, is now prepared to make, and take the appropriate steps to support the dollar, not just give it the half hearted lip service of the past.
The First Phase by the Fed: Get the Financial Markets Functioning
The Fed as a result of the banking, housing and credit crisis over the past year, has flooded the market with dollars in an attempt to save the financial markets. During the process the Fed lowered the short term rate to 2.00% from a high of 5.25%.
The banking system did calm down although recent financial institution downgrades from S & P and rumblings about additional write offs are still prevalent. However, the downgrade is probably a lagging rather than leading development and rumblings are just that, rumblings.
The credit markets are not out of the woods by any means. Exposure of mortgage portfolios are hard to quantify as foreclosures continue and liquidity conditions are limited.
Nevertheless, from the Bear Stearns low point, it can be said the financial markets are better - and who knows may be more normal. In addition, one can assume that the Fed, nor the markets, want to necessarily return to the overly liquid days that characterized the pre-crisis time period. Controlling risk, rather than piling on risk seems to make more economic sense. Financial institutions should now be keener on who are their customer, what are their risks, and what they need and have available to them in order to manage that risk. Whether Wall Street wants to admit it or not, financial institutions and markets lost sight of those basic fundamentals pre-crisis, and it manifested itself into the demise of Bear, and a whole lot of fear about others.
The hope now is that the lessons have been learned and lenders are now back to following the fundamentals of lending, the financial engineers (and rating agencies) who bundle securities for sale, now do so in a responsible and reasonable manner, and that risk managers at major financial institutions know the risk and have a much better handle on the liquidity available to them to manage that risk.
What about the US consumer?
Housing, a major asset for most consumers is still in trouble at least on paper. For others it is a real problem as demand by buyers is still stagnant. The supply of homes on the market remains at the highs with over 11 months supply remaining on the market. As a point of comparison, the high end from January 1999 to January 2006 was 5 months (see chart).
Unemployment is moving higher which hurts but it has also helped keep wages under control. The change in NFP although negative for 4 straight months, has not approached the levels that prevailed during the 2001 to 2003 period. Growth has slowed with GDP barely growing. Consumer confidence is at record low levels.
Despite the slow domestic economy, inflation has continued to move higher led by the spike in a gallon of gasoline which has reached up to $4.00 a gallon in the higher tax states.
The economic cocktail of low growth, slowing employment, a horrible housing market and higher inflation has made the consumer feel quite sick. As a result a spiral has developed where inflation rises, while confidence and housing declines almost each and every month (see chart on the previous page).
What is the catalyst of the current consumer spiral?
When the Fed started its easing cycle the intentions were focused on growth and behind the scenes the health of the financial market. The announcement of the first 50 basis point cut included the following statement,
“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
Although the Fed could not directly say it, the state of the financial markets was a main worry. Central bankers know an economy is only as good as the financial markets and institutions that support it. They just could not say they were “bailing out the banks” for fear of reprisal from the general public (and Congress).
Meanwhile the comments from the Fed on inflation have had some common elements but have gotten worse as growth slowed. After the first meeting the following was said: “…some inflation risks remain, and it will continue to monitor inflation developments carefully”. After the last cut on April 30th, the following was said, “…uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.” Despite slower growth, inflation remains. Part of the reason can be found in the inflation statistics.
Since the slowing began in earnest in August of 2007; the Consumer Price index has risen from 2% to a high of 4.3%. The Producer Price index has risen from 2.3% to a high of 7.4%.. Both measures are alarming, but they do not compare to the rise in Import Inflation. Over the same period the Import Price Index has increased from 1.9% to 15.4% last month .
Clearly as one problem was being solved, the implication of the easier money has had a measurable impact on the value of the dollar that created other problems – namely import inflation. With the dollars decline, the prices of imports have risen dramatically. Furthermore, since oil is denominated in US dollars, oil exporters had little incentive to keep the price of that precious commodity low. This has helped lead to the meteoric rise in the price of oil which makes production costs much higher for all businesses (and in turn consumers).
Now the Second Phase. Support the Greenback and Bring Inflation Down
Now, it seems the Fed and Treasury is having a change of heart on the value of the dollar and is willing to support the currency, rather than let to fall freely. The hope is that now that the tax rebate checks are being mailed and the declines in economic growth may get a boost, that a dose of confidence in the greenback may ease the pressure on the oil and commodities, which in turn will ease the inflationary numbers. Lower inflation will bring confidence back to the consumer who may not go out and spend like fiends, but work at shoring up their balance sheets. In addition, if jobs can be saved and inflation can be lowered (especially energy inflation), perhaps buyers will reemerge into the housing market and start to lessen the supply of homes on the market. The housing market is still the wild card which has the Fed and Mr. Bernanke concerned. It must start to show signs of some life to keep the dollar supported.
All of which will not happen overnight. The economic numbers will continue to show sluggish to weak growth. Housing still has to have price reductions (which makes housing more affordable to new buyers). Inflation, especially on a year on year basis will most likely still increase for a time period. In the meantime, the US consumer has gotten a pretty good scare and may start to do their best to conserve energy (how many people do you know who are looking at cheaper more energy efficient smaller cars now?), live more within their means and act ….well sensibly.
Remember, even steady prices start to make the economic numbers look better over time. As a 0.6% month on month inflation increase is replaced by a 0.1% increase, the year on year figures start to likewise decrease. The problem of late is that the month on month increases have all been on the high side – a trend the Fed should indeed dislike.
In addition, the Fed and Treasury is also hoping that perhaps there is an element of speculators in some of the commodity markets like oil, and a rise in the value of the dollar may punish their greed. Clearly, a decline in the price at the gas pump will go a long way toward making people feel better.
The markets will want to see the resolve in the Fed. It may require a dose of ECB hawkishness. It may even require a tightening or two at some point, if things do not go their way, but at least it seems that the dollar may not be the whipping boy it has been accustomed to and the United States should be better off because of it in the long run.
- Greg Michalowski –Chief Foreign Exchange Analyst
