Lenin was right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. -- John Maynard Keynes What will Ben Bernanke's stance on the dollar be? That question has haunted foreign exchange markets since his appointment Monday to replace Alan Greenspan as Federal Reserve chairman. Of course, the "haunting" was limited because Bernanke still has to clarify what his official stance will be, and that may differ radically from his previous thoughts on the matter. In addition, the dollar policy falls under the realm of the Treasury Department, not the Fed. But the fate of the greenback is implicitly intertwined with monetary policy. A strong dollar keeps inflation at bay by lowering the cost of imports, while a weak dollar can boost the economy by fueling exports and inflating overseas profits. The Fed's twin policy mandates are price stability and full employment. On Monday, the dollar dipped as news agencies reported Bernanke's imminent appointment. The dollar then bounced back, after confirmation of the news, as Bernanke guaranteed "continuity with the policies and policy strategies under the Greenspan era." The dollar has been supported this year by the Fed's unwavering commitment to continue raising short-term rates. Fed tightening means more attractive yields in short-term Treasuries vs. their foreign counterparts, encouraging foreign flow of capital into the U.S. The dollar was down again Tuesday, although traders attributed the move to euro strength overnight following strong gains in Germany's Ifo survey of business sentiment. But in a sign of ongoing uncertainty about Bernanke's commitment to keep up the fight against inflation, gold surged more than $7 to $474.20 an ounce. Likewise, the 10-year Treasury was recently down 7/32 while its yield, which moves inversely, rose to 4.47%. The benchmark note fell 15/32 on Monday. Major averages, meanwhile, were taking a breather after Monday's furious rally, thanks in part to disappointing earnings from Texas Instruments ( TXN) and DuPont ( DD). The Dow Jones Industrial Average was recently down 0.5% to 10,338, the S&P 500 was off 0.7% to 1190.85, and the Nasdaq Composite was down 0.9% to 2097.73.
Past as Prologue?
Based on previous comments by Bernanke on the dollar and inflation, there were some reasons for dollar bulls to be jittery. In 2002, Bernanke was among the first and most vocal members of the Fed to warn of the dangers of deflation. In a
November 2002 speech that has since become famous, Bernanke advocated not only for looser monetary policy but also for the Bush tax cuts, both of which could generate "positive inflation" to prevent deflation. In addition, he said:
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.He also famously said in the same speech that "a money-financed tax cut" is essentially the same as dropping money from a helicopter. Amid concerns that huge fiscal spending to rebuild Katrina-hit southeastern states would also spur inflation next year, the "printing press", "helicopter" and "positive inflation" remarks may come back to haunt markets. One could reasonably argue that these remarks were three years old and that the situation has now considerably changed, what with the surge in inflationary pressures after the most recent energy-price spikes. But in an interview with The Times of London last week but published Tuesday, Bernanke downplayed concerns that energy-related inflationary pressures would seep to core inflation. "The evidence seems to be that it is primarily in energy and some raw materials and has not fed into broader inflation measures or expectations," he said. "My anticipation is that's the way it's going to stay." Bernanke was also very dovish on the federal budget deficit. Noting that it was about 2.6% of GDP this year, he said "that's not far above the long-term average." Then there are Bernanke's views on the current account deficit. In order to finance the gap in the current account, which is the difference between imports and exports of goods, services and transfers (including financial flows), the U.S. has relied on foreign purchases of U.S. financial assets, especially Treasuries. But this leaves the economy vulnerable in case these purchases were to drop suddenly, which could send the dollar sharply lower and U.S. interest rates sharply higher. Such concerns were evident in the market earlier this year.
Many economists believe that the historically low interest rates put in place by the Fed three years ago have encouraged borrowings at shorter-term interest rates for investments in longer-term and therefore "riskier" investments. But in a
March 2005 speech , for which Bernanke blames squarely "a global savings glut," for the U.S. current account deficit. A shift that has transformed developing economies "from borrowers on international capital markets to large net lenders" to the developed world and the U.S. This suggests that in Bernanke's approach to reducing the current account deficit would not emphasize the need for higher U.S. rates to encourage more savings at home (the current savings rate in the U.S. is negative). That is, consistent with remarks he has made in the past few months while chair of the Bush administration's Council of Economic Advisers. Instead, he is more likely to pressure China to accelerate the process of delinking the yuan from the dollar, a move expected to boost U.S. exports and reduce the trade deficit over time, according to Tony Norfield, chief foreign exchange strategist at ABN Amro. The export-led economic boom in China, fueled by a cheap yuan, has led China to accumulate huge reserves of U.S. dollars, which it has used to buy U.S. Treasuries. While "Greenspan was such an advocate of free trade that he never wanted to publicly to accuse trading partners of pursuing export-enhancing foreign exchange policies ... our guess is that Bernanke will be more judgmental," Norfield says. The new Fed chair appointee, Norfield notes, is also known for being more "plain spoken" than Greenspan -- which is arguably not too hard. Finally, while Bernanke is known for being independent-minded, his appointment nonetheless smacks of political considerations, as noted here yesterday. With congressional elections looming next year, the auto and airline industries in chaos and the real estate market cooling (threatening consumption), pressure is going to be intense on the new Fed chairman to cut rates -- or at least be less aggressive with tightening. Maybe the dollar and bond bears -- and the gold bulls -- have it right.