Erstellt am: 12.06.2008 Autor: Edward Roby Status: Senior
12/06 2008
Central banks declare war on resurgent inflation
Lance or sword, what shall be thy pleasure, Sir? Like medieval knights, Ben Bernanke and Jean-Claude Trichet chose the first week of June to frame what sound like new rules for the next round of the 10-year-old transatlantic tournament of currencies.
Introducing the revised terms of engagement with a polite flourish was the embattled dollar champion. In a June 3 speech for satellite delivery to a Barcelona bankers’ forum, Bernanke demonstratively shifted the Federal Reserve’s policy spotlight from the cooling U.S. economy to the neglected value of the dollar. The words alone triggered a brisk dollar rally and stiffened short-term dollar interest rates. Some market participants even detected an end to the prolonged weakness of the dollar – against other currencies, of course.
Two days later, the euro monetary steward implicitly took up the gauntlet by raising the prospect of a modest rate gambit by the European Central Bank. “We are not ruling out the possibility that we will raise the leading interest rate by a small step at our next meeting,” Trichet announced. Touché! This time it was euro’s short rates that stiffened -- so much so that the bond yield curve became uncharacteristically inverse. And the upstart common currency, which had been retreating from its record peak of $1.60 on April 22, instantly rallied back to $1.5589.
Was this apparent verbal joust a mere coincidence of timing? Naturally, the transatlantic repartee was framed in the ritualistic language of central bankers, who chivalrously distain to acknowledge any vulgar competition for capital flows among competing currency spheres, let alone the mean-spirited tactic of deliberately targeting a rival’s exchange rate. The field of friendly strife was instead marked off again as an honorable mutual struggle to vanquish resurgent inflation. Not so much the good old home-grown, bubble-making inflation, but the really evil variety that somehow comes from abroad.
Inflation on cue
But the mounting threat of inflation did not come out of the blue, becoming acute simultaneously for dollar and euro monetary stewards alike only at the start of June. A dangerous upward price spiral has been brewing on both sides of the Atlantic for quite some time. The inflation in the United States is partly also collateral damage from the Fed’s own campaign to reflate its ravaged financial sector and the struggling real domestic economy since the latest financial crisis erupted last August. This urgent race against deflation has featured slashed interest rates, massive infusions of liquidity, a $30 billion public bailout of one large derivatives broker and unprecedented public guarantees for private financial firms. Having blunted deflationary momentum in the financial system and stagnation in the real economy for the moment, U.S. financial strategists are now wheeling about to parry the latent inflationary threat. And that calls for immediate first aid for the neglected dollar.
The Federal Reserve, which normally defers to the Treasury Department on dollar pronouncements, has suddenly taken note of the plight of the world’s reserve currency. The weakened dollar has “contributed to the unwelcome rise in import prices and consumer-price inflation,” Bernanke said in his June 3 speech. The Fed is “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,” he added.
His pledge of a Fed policy of “ensuring that the dollar remains a strong, stable currency” dispelled any lingering market doubts that the 2% Fed funds rate, cut seven times from 5.25% since last September, will be as low as it goes for a while. The tough language on monitoring foreign exchange developments not only buoyed the dollar but also prompted market speculation about concerted dollar-buying interventions with foreign central banks. Yet, Trichet’s euro rate rejoinder quickly cast some doubt on that notion.
Reserve role in jeopardy
The European Central Bank has also expressed discomfort with the strength of its euro against the wilting dollar – but not enough to import more inflation by easing its own leading interest rate. Euroland’s annualized consumer inflation rate was quoted in May at 3.6%, well above the 2% ceiling regarded as tolerable. And the broad money supply continues to grow at double its targeted pace. So, the ECB president reaffirmed his consistent focus on price stability at the same Barcelona bankers’ forum addressed by Bernanke. And his rate surprise two days later served notice that ECB is now considering a quarter-point increase in the leading 4% euro interest rate when its council reconvenes in July.
Central banks in general, especially those whose currencies are pegged to the dollar, would undoubtedly welcome an end to dollar depreciation. Under the circumstances, though, none of them can be particularly keen to acquire still more greenbacks. With the U.S. economy still teetering on the edge of recession, the Fed’s options for defending the currency with more than strong words seem limited. The Fed’s bluff would be called if ECB, presiding over the stronger real economy at the moment, actually hikes interest next month.
The Fed’s new foreign exchange sensitivity closely follows reports that a couple of Arab Gulf states were contemplating the severing of their currency pegs to the dollar because this has been aggravating local inflation. Kuwait had already taken that step last year. The effort to maintain dollar parity forces countries to match the Fed’s interest rate reductions or increase their money stock to buy dollars. Iran’s oil ministry, moreover, said in April that euros or yen rather than dollars are being accepted in payment for its exported oil. Iran and Venezuela have urged OPEC to abandon dollar pricing of oil exports, a move Iraq took in 2000 but which has since been reversed by right of conquest. And the East Asian giants of dollar reserve holdings have been seeking new ways to diversify their investments. None of that speaks for confidence in the dollar.
Treasury Secretary Henry Paulson, who just met with leaders of the wavering Gulf states, has been talking up the desirability of a strong dollar since at least last November when the Fed was frantically pouring easy money into the seizing credit markets. The markets ignored Paulson’s message, preferring to take their cue from the incompatible facts being created by the Fed’s actions. The dollar has since then touched record lows against a basket of currencies. Results are now showing in lofty prices for imported energy and key commodities.
Subprime crisis morphs into consumer price spiral
Financial investors, some of them fleeing the mortgage-lending and securitization fiasco, have aggravated the problem by flooding into unregulated commodities futures as a hedge against oncoming dollar inflation. This speculative effect has contributed to more than a doubling of the international oil spot price to around $130 a barrel since the start of 2007, although oil stocks are high, U.S. refineries are running with fallow capacity and demand has scarcely changed.
Forward market speculation by banks, hedge funds and other institutional investors can also be observed in other key commodities and grain prices, converting subprime financial deflation into consumer price inflation. The understated U.S. inflation rate reached 4% for April. Soaring prices for food and gasoline have become a political powder keg. But real interest on short-term Treasury paper is now negative. And the Fed’s rate-cutting frenzy has erased the dollar’s yield advantage, discouraging the capital inflows needed to finance the U.S. trade deficit. This ugly constellation of Fed concerns puts Trichet’s ECB in a comparatively enviable position.
The Federal Reserve was undoubtedly aware of those latent risks when it chose last September to deal first with the imminent deflationary threat to the financial system and the domestic economy. Obvious, an inflationary weakening of the dollar looked like the lesser of two evils at that time. Apparently the tables have now turned. By ending its campaign of rate easing, the Fed might be able to stabilize the dollar for a while.
Knight without a steed
But a past episode of galloping inflation in the 1970s took years to quell with Fed rates that topped 16% at one point. And there is scant prospect of such U.S. monetary tightening in sight now because the financial meltdown continues and real economic growth – GDP grew by 0.2% in the opening quarter and the official jobless rate climbed last month to 5.5% – is minimal. Beyond verbal intervention, the Fed’s hands are probably tied. Deprived of wiggle-room for interest tightening, Bernanke looks no more ready for transatlantic currency competition than an armored knight who has lost his horse.
If there is now genuine interest in Washington for defending the damaged dollar, however, international confidence could be restored with the tried and true method of responsible fiscal and monetary policies. The ideal dollar defense would have to begin with serious government austerity to balance the federal budget and to start paying down the ballooning U.S. debt. But that would be neither quick nor easy. And in the midst of a presidential election campaign, quick and easy always trump long and hard.
