Will Bernanke Save the Dollar?
Recent hawkish comments by Federal Reserve (Fed) Chairman Ben Bernanke caused jitters in US and global equity markets; as is the typical first reaction when there is a sense of panic in the market, US investors liquidated some of their more speculative foreign investments and repatriated the money. As a result, the dollar enjoyed an overdue rally after it had been sliding for weeks versus major currencies. Did Bernanke ring in a new era at the Fed? Will he be able to help contain inflationary pressures? And will the dollar regain its strength?
When we recently analyzed whether nominated Treasury Secretary Paulson could save the dollar, we pointed to the fact that policies reining in domestic consumption would reduce the current account deficit, and as a result alleviate some pressure on the dollar. Politicians rarely call for a drop in consumer spending; this unpopular task is traditionally left to the Fed. The Fed controls money supply and interest rates; and while the Fed has continued to boost money supply, higher interest rates are starting to take their toll on the consumer. Does that mean a slowing US economy translates into a higher dollar? Not quite...
Bernanke spooked the markets by daring to say what has been ignored for too long: inflation is heading our way. We already experience inflation on anything we cannot import from Asia - from the cost of healthcare and education to the cost of local services. Low interest and tax rates in the US, combined with Asia's growth policies have created an oversupply of goods has lead to low consumer goods and high commodity prices. Corporate America has up till recently been faced with little pricing power because consumers neither needed to pay more for goods (cheap imports), nor could they afford to (high debt); to maintain margins, outsourcing was accelerated, keeping a lid on job and wage growth. Slowly, but surely, however, inflation has been creeping through the production pipeline. Gradually, wage pressure is increasing; corporations are finding ways to pass on higher prices; and finally, some of these pressures appear in government statistics.
Bernanke has a problem, a big problem: inflation is creeping up just as the economy is slowing down. Some have pointed out that it is quite common for inflation to continue to climb for a couple of months as the economy is slowing down; as a result, we should not be concerned about it. These are the same 'experts' that only saw the internet bubble out of the rear view mirror and are still do not acknowledge there is a housing bubble. What many underestimate are the extremes we face:
- Inflationary pressures have been ignored for a very long time because they did not make it through to the government's "core inflation" statistics. The Fed relied on globalization to contain inflation.
- The consumer is far more interest rate sensitive than ever before. Just about everything is bought on credit now. Bernanke's predecessor Greenspan loved this "efficient" consumer. The problem is that this efficient consumer has to cut back much more sharply when faced with higher interest rates (or shocks, such as losing a job).
As interest rates edge up, the economy will slow down sooner than it would if the consumer was not as interest rate sensitive. This is exacerbated as consumers can no longer extract additional equity out of their homes. We do not need falling housing prices to harm consumer spending - stagnant prices are harmful enough. Anecdotal evidence also suggests appraisers are under a lot of pressure to keep up the values of homes to allow those who want to refinance to lock in still low long-term rates. All those who have taken out 100% mortgages while locking in only 1, 2 or 3 years will learn that they can only refinance if their property is assessed to be worth at least as much as their mortgages.
Indeed, in the comments that rocked the markets, Bernanke not only talked about rising inflationary pressures, but also about a pending a slowdown in consumer spending. These are problems that require diametrically opposed Fed policies. If the Fed is to fight inflation thoroughly, it will - in our assessment - cause a very severe recession, if not depression; and if the Fed was to ease, inflation is going to be a very serious issue.
So Bernanke does what all central bankers would do in this situation: talk tough. It's the cheapest of all policies in the arsenal of Fed tools, and it works - for a while anyway.
What about action? We believe the Fed will raise rates just far enough to throw the US economy into recession, but not far enough to contain inflation. The price of gold above 600 dollar an ounce shows that many are share the view that the Fed will not impose a severe recession onto the country.
What are the implications for the dollar? While a slowing US economy may alleviate the current account deficit, it also discourages investment, in particular foreign investment. Why should foreigners invest in the US when it is perceived that there are better opportunities elsewhere? We don't need foreigners to stop investing in the US, but simply to invest a little less to cause a problem for the dollar: with a current account deficit in 2005 exceeding $800 billion, foreigners need to invest over $2 billion in US dollar denominated assets every single day, just to keep the dollar from falling. Foreigners will need to buy less should there be a domestic slowdown, but will foreigners be just as willing to finance the trade and budget deficits?
Going back to what Bernanke may do about the dollar, don't expect help. First, Bernanke has broken the taboo that the Fed ought not to talk about the dollar, but leave that up to the Treasury Secretary. That taboo has been there for a good reason, namely to maintain trust in a fiat currency not backed by gold, but only the faith in our politicians. He explicitly discussed the dollar in testimony, and dedicated a full paragraph to it in the latest Fed minutes. While sometimes it is unavoidable to talk about the dollar as the Fed Chairman, he seems to seek the discussion. Bernanke, a self-described student of the Great Depression, considered the strong dollar an important reason why the Depression was as long and as severe. Part of Bernanke's rise to fame as an academic comes from his role as an advocate of Japan's ultra-loose monetary policy.
All of this leads us to conclude that Bernanke will not come to the dollar's rescue. With many policy makers favoring a weaker dollar, and the weight of the current account deficit continuing, we think that the recent strength in the dollar may be temporary. We have noticed far broader interest in the dollar's fate - a sign that many are getting concerned about what it means for their investments. Investors are realizing that a slowing US economy may be a bad omen for US equity & real estate markets, as well as for investments in many speculative places overseas. There is a lot of disagreement about what is going to happen in the bond markets as it struggles whether to focus on a slowdown or inflation. As many investors are looking for safety, be aware that US dollar cash is no longer the safe haven to revert to. In our view, one has to take a diversified approach even to "safety" - gold has traditionally fulfilled this role, although gold can be in itself rather volatile. "Hard assets" traditionally fulfill this role, although be aware that real estate with its inherent leverage is unlikely to fulfill this role; it is of no surprise to us that a Picasso was recently auctioned off for $90 million. One can also consider taking a diversified approach to cash itself, such as through the Merk Hard Currency Fund we manage.
We would also like to invite you to a Web conference on Wednesday, June 21, 2006, where we discuss the pressures on the dollar in more detail (click here to register). We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.