Financial Advisor Update

Fed Has Lost Control Over Interest Rates

Stock quotes in this article: FNM , AEOS , ANF , WTSLA  

The dollar didn't stabilize until the next day, when revised figures on third-quarter gross domestic product showed the economy growing by 2.2%, rather than the 1.6% rate in earlier data. That was stronger growth than the 1.8% that financial markets had expected, and it provided enough credibility to Bernanke's remarks to push the dollar up 0.3% for the day.

Still in the Woods

The dollar faces three big problems, none likely to go away quickly:

  • There's that whopping U.S. trade deficit. Even though lower oil prices led to a drop in the September trade deficit to a mere $64 billion from the August record of $69 billion, it is on track to break $750 billion this year. That deficit has to be balanced by cash flows from overseas investors who provide the extra money that we spend to buy foreign goods and services. This puts more dollars in the hands of overseas investors and central bankers who are already worried about what to do with the dollars they hold.
  • Second, there's the slowing of the U.S. economy in 2007. Yes, the revised third-quarter GDP growth at 2.2% was good news, but the economy is still in slowdown mode -- second-quarter growth was 2.6%, after all. There's a good likelihood that U.S. growth will lag growth in Europe and Japan for at least the first half of 2007.
  • Third, U.S. interest rates aren't headed any higher at a time when the European Central Bank and the Bank of Japan are still raising rates. That will lower the yield gap between U.S. interest rates and those in Europe and Japan, and as a result, the price of U.S. notes and bonds is likely to fall, while those issued in euros and yen climb.

Put it all together -- a global dollar glut, a slowing U.S. economy and rising euro and yen yields -- and pressure on the dollar is likely to continue well into 2007. In my opinion, the dollar will stay under pressure until Japan and Europe signal a rate pause, and until the U.S. economy starts to re-accelerate or those of Japan and Europe start to slow.

Long-Term Implications

This week's stumping for a stronger dollar by the Federal Reserve and the Treasury marks a shift of priority for U.S. monetary authorities. Yes, fighting inflation remains important to the Fed, and, yes, the Fed would prefer not to tank the economy. But Bernanke and company know that the tough choice must be made: Managing the dollar is more important at this point than managing inflation or growth.

That's because the huge piles of dollars sitting in the vaults of the central banks of China, Russia, Japan, the OPEC countries and the European Union are large enough that they make overseas bankers nervous. When you hold 700 billion U.S. dollars in reserve (out of a total $1 trillion in foreign-exchange reserves), as the Chinese do, for example, every penny decline in the value of the U.S. dollar makes you nervous, since it represents a drop of $7 billion in the value of your dollar holdings.

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