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Market Directions Sunday, March 2, 2008

Mon, Mar 3 2008, 10:58 GMT
by Joseph Trevisani

FX Solutions

A Bodyguard of Lies

Federal Reserve Vice Chairman Donald Kohn’s speech on Wednesday broke the stalemate between the dollar and the euro. Warning that slower economic growth is a “greater threat” than inflation, Mr. Kohn helped turn a stop driven run through 1.5000 in the Australian market into a full fledged paradigm shift. And when he was seconded by Federal Reserve Chairman Ben Bernanke’s gloomy Congressional testimony that the economic situation had become distinctly less favorable and that the Fed “will act in a timely manner as needed” the speculation for Fed rate cuts beyond the March 18th meeting moved into high gear. The futures market now expects a 2.00% Fed Funds target rate by May Day; a 65 basis point reduction at the March 18th FOMC meeting and another 30 points by the end of April.

It would be easy but inaccurate to blame the Fed Chairman and Vice Chairman for the dollar’s collapse. But it would be accurate to say that that they and the Fed governors have done little to temper the dollar decline brought on by their policies. The Fed has not so much talked the dollar down as refused to provide rhetorical support. To be fair official dollar policy is not the purview of the Fed but belongs to the Treasury Department headed by Hank Paulson, the former CEO of Goldman Sachs. But in the current economic environment Mr. Bernanke has been the chief spokesman for economic policy and his omissions do not jibe with the standard US strong dollar policy as reiterated by President Bush and Secretary Paulson. When the Fed Chairman says the obvious, that a weak dollar fosters US exports, currency traders hear not the description of a currently weak dollar but a prescription for a much weaker dollar in the future.

Mr. Bernanke’s has long said that the economic facts will dictate Fed policy and he has been uncommonly open in discussing the statistics and methods that the Fed uses to arrive at policy. But his transparency on Fed rate policy ties that policy very tightly to those statistics. Traders know the economic facts, none better. US economic statistics on GDP, business planning, employment, consumer sentiment and inflation are full of distress. If the economy is not in outright recession the signs are not pointing in any other direction. But traders no longer have to wait for Fed pronouncements to ascertain its next policy move they only have to read the economic tea leaves.

Any economic policy can have can have both desirable and undesirable elements. Lower American interest rates are a current necessity for the US economy and financial system. But lower rates devalue the dollar, exacerbate inflation, strain international economic relations, contribute to commodity price inflation and generally undermine the stability of the world financial system. For a central banker, a rapidly devaluing reserve currency is something to be avoided if at all possible. The dollar has depreciated more than 13% against the euro in six months. But at no point in that decline has the Fed spoken convincingly in defense of the US currency. Why?

Central bankers often use rhetoric to ameliorate the undesirable effects of a policy or to push the markets in a direction without employing the bludgeon of interest rate policy. Hectoring the markets can be quite effective in the short term.

However, the policy transparency of the Bernanke Fed has worked to limit the effectiveness of its rhetoric. Currency traders can read economic data almost as well as the Fed, but because Mr. Bernanke has so carefully delineated the logic and evidence behind its decisions they no longer need to wait for the Fed, nor are they checked by doubts as to what that decision will be. Speculative positioning is given a freer rein. Mr. Bernanke has not sought to check the market with rhetoric. Granted, it would not be logical to reduce interest rates and then warn the market that inflation was still a major concern. It would not be logical. But if the goal was to temper the decline of the dollar, it would be effective.

Contrast the Fed policy with that of the European Central Bank under Jean Claude Trichet. At the last ECB meeting the bank’s official statement and pronouncements were universally interpreted to mean that the bank had moved to a neutral rate stance. The euro promptly fell. Worsening economic conditions in the US, if not yet in Europe, would, it was assumed prevent the ECB from raising rates even if inflation accelerated. The ECB neutrality was an acknowledgement of that fact. But a strong euro is a hedge against the ECB’s main concern -- inflation. In addition, European unions are demanding hefty wage increases which are the primary second round inflation effects the bank is trying to prevent. The central bank does not want a sinking euro to complicate its anti-inflation fight. So the ECB immediately turned up the rhetorical heat. Mr. Trichet, Axel Weber and other governing council members were repeatedly quoted in the media warning of inflation and stressing the bank’s determination to prevent the ascent of inflationary expectations. The euro returned to the middle of its range against the dollar. It was not logical but it was effective.

The Bernanke transparency on Fed rate policy has had the perverse effect of limiting the Fed’s options. Because Mr. Bernanke has so carefully outlined the logic of Fed policy and the statistics that it watches and because he has so carefully kept to his open precepts the chairman cannot credibly gainsay the statistics or the Fed policy with rhetoric. He cannot do what the ECB did, adopt a neutral rate stance one week and then deny that it had done so the next.

Mr. Bernanke’s acknowledgement before Congress and a thousand trading room televisions that a weaker dollar bolsters US exports may be true, but it is not helpful. It only worsens the dollar decline. Unless a lower dollar is the Fed’s goal, such talk it is counterproductive. A little doubt about the Fed’s intentions could go a long way right now. Doing one thing and saying another is probably just what the dollar needs. Mr. Trichet seems to know this, Mr. Bernanke does not. To quote Winston Churchill, “In wartime truth is so precious that she should always be attended by a bodyguard of lies”. The dollar could use such a guardian.

Joseph Trevisani

FX Solutions

Chief Market Analyst

Joe@fxsol.com

Published on  Mon, Mar 3 2008, 11:00 GMT