Fed Chairman Bernanke Surprises World with Dollar Comments

Posted by Patrick O'Connor on 6/3/08 12:51 pm

U.S. Federal Reserve Chairman Ben Bernanke unexpectedly voiced concerns about the weakening U.S. dollar and its inflation ramifications today at the International Monetary Conference in Barcelona, Spain.  Read more.

“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,” said Chairman Bernanke. Read full speech.

Bernanke’s dollar comments were a bit unusual for a Fed chairman.  Normally such comments are reserved for Treasury officials.  However, the economy is reaching a point where something has to be done about the rampant commodity inflation in order to protect the economy’s long-term viability.  And the dollar is an excellent place to start.  After all, the greenback has been tanking for quite a while.

But should we expect a sustained rebound in the dollar now that the Fed chairman appears to be targeting such an occurrence?

The Dollar: Short-Term Rebound, But After That – No Promises

Dollar-bashers say that the U.S. dollar is in a major long-term bear market, and are advising investors to keep their exposure to the dollar at an absolute minimum. They’re also recommending that all long-term savings and investments should be denominated in select foreign currencies against which they believe the dollar is likely to fair the worst.

Critics also say that economic policy decisions by the U.S. Federal Reserve have been greasing the skids for the stock market’s demise, primarily by flooding the world with dollars and credit. M3 – the economic term for the U.S. money supply – is growing at a 12% annual clip. Relentlessly pumping the dollar into the money supply has triggered a devaluation of the greenback – and helped inflate food and energy costs as an aftereffect.

Other signs are equally ominous . . .

• Dollar devaluation in the 1930’s coincided with the biggest bear market in history.

• After the US went off the gold standard in the ‘70s, a 10-year bear market followed.

• The Crash of ’87 was preceded by a 35% devaluation of the dollar against major currencies.

That’s the bad news for the dollar.  But there is some good news.

The dollar has stabilized since hitting an all-time low in mid-March. It’s rebounded nicely, albeit moderately since then. Historically, the dollar rises during periods of domestic economic strife. We’re not saying we’re in a recession, but it’s evident from the relevant data that the dollar has rallied during four of the last five U.S. recessions.

Thus, a burgeoning parade of economic forecasters say the outlook for the buck is brightening. Dr. Steve Sjuggerud, writing in a recent issue of the Investment U. newsletter, predicts the U.S. dollar should rise by 20% or more in the upcoming months.

Sjuggerud, writing from an economic conference in Switzerland, where the dollar has “crashed” and Americans pay $500 for one night in a hotel and $60 for a lunch of filet and salad, sees three key indicators that tell of better days ahead for the beleaguered U.S. currency.

Interest rates. All things being equal, the country with the higher yields will see its currency rise versus the country with the lower yield (deposits in the U.S. pay nearly 3%, while Swiss ones pay less than 1%).

Purchasing power. When one developed country’s currency is significantly out of line with another developed country’s currency, it’s like a stretched rubber band - things return to “normal” over time. (A Big Mac in Switzerland, for example, is 82% more expensive than a Big Mac in the States, according to The Economist magazine).

The underlying trend. Trends in currencies tend to stay in motion for longer than people think. Recently, the trend in the European currencies has been down versus the dollar, but so far the fall has been minimal… and there’s plenty more room on the downside in the euro and Swiss franc.

Conversely, the euro, which has run rings around the dollar in the past few years, is showing signs of slowing down, says Sjuggerud. He reasons that interest rates are lower than the United States, at closer to 2%. He also points out that a Big Mac in Europe is 25% more expensive than the U.S., but there is no good reason for it. “The Big Mac will return back to “normal” pricing in euros,” he says. “And the way that will happen is the expensive euro will lose some of its value.”

Consequently, all the “ducks are in a row” for the U.S. dollar to continue its rebound.

Of course, that’s his opinion. What might be closer to reality is that while the dollar may continue to surge (somewhat) in the short-term, long-term indications are working against any monumental U.S. currency recovery. That’s more or less Warren Buffet’s opinion. He recently told Bloomberg.com that “The U.S. dollar will keep weakening” and that he feels ``no need to hedge’’ against currency risk when buying large companies outside the U.S.

Buffet thinks the dollar will surge moderately against the euro this summer and into the fall. That’s primarily due to the fact that the Federal Reserve’s rate cuts are likely finished, and any hint of a hike in the fed funds rate in the future will boost the dollar. As stated above, the slowing U.S. economy should also bolster the dollar.

Working against the dollar’s rebound is the rising specter of inflation, which could plant the seeds for another prolonged decline in the dollar in late 2008 and early 2009.
For a more definitive look at the dollar and where it might go, check out one view from overseas.

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