Higher Interest Rates Wont Help the Dollar
As U.S. inflation is beginning to be taken a bit more seriously, the dollar has found some temporary support as traders anticipate higher interest rates from a more aggressive Fed. Ironically, foreign investors attracted to the higher yields will be stung by the declining value of the dollar which must result from higher inflation. (See my commentary of April 6th 2005 "Hello, Inflation is not Good for the Dollar" available here.) Therefore, even if in the short term higher rates may buy the dollar some time, in the long run the dollar will buy much less. However, even if we were to ignore inflation's impact on foreign exchange, the investment logic itself is flawed as it does not factor in the U.S. economy's vulnerability to higher interest rates.
To be viewed as bullish for the dollar, inflation is operative only when one believes that the Fed is firmly committed to fighting it. Lost in translation is the fact that the Fed's anti-inflationary rhetoric may be just that - rhetorical. While bad news for savers and investors, higher inflation is actually the government's best friend and is the most politically expedient way to resolve America's economic imbalances and reduce the real burden of repaying its own debts.
When higher interest rates really start to take their toll on consumer spending and home prices, the Fed will either do an about face and start cutting rates in a desperate attempt to revive the economy, or it will continue to raise them, deliberately pushing the economy deeper into recession. Both scenarios are bearish for the dollar, and it is only a matter of time before the market figures this out.
It is also ironic that Stephen Roach, who recently capitulated his long-held bearish position on the global economy, just added his voice to the chorus calling the rise in commodity prices a bubble. His principal reason for doing so was his observation that given that there is no inflation, commodity price increases of the magnitude recently experienced were unwarranted, and should therefore be reversed. That is like expecting an obese individual to lose weight simply because he claims to be dieting, while ignoring his third trip to the buffet table.
The fact that Wall Street's brightest stars accept the current environment as non-inflationary, while they stare at commodity prices that skyrocket on a daily basis, demonstrates how successful the government has been in its disinformation campaign. With the bill of goods firmly grasped, they expect prices to fall rather than question the inherent irrationality of the government's claims. Just as Roach's declaration that America's economic imbalances were no longer problematic likely means that they will soon weigh heavier than ever, his pronouncement of inflation's absence likely means it is finally about to spiral out of control.
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