Weak Dollar: Who's Fooling Who?

Now Morgan Stanley's Dick Berner joins the club. The Fed is on the move, and 'unconventional tools' are the order of the day. In the light of all the new converts my January dollar post is looking pretty good right now. As Naipaul has it, it's not so much what you say as when you say it. So how long before we get a change of consensus perspective on Fed and Treasury attitudes towards that other deficit, the fiscal one?

With the Fed running out of basis points to first stabilize and then slightly boost inflation, officials and market participants have focused on so-called 'unconventional tools' in the policy kit, including oversupplying the system with reserves and buying securities along the yield curve. In my view, however, that focus is premature. That's because the Fed is already quietly using another key weapon in its deflation-fighting arsenal, namely a weaker dollar. To be sure, the U.S. Treasury officially has the reins of dollar policy, and Secretary Snow has stuck to the strong dollar mantra. But the Fed is really in the drivers' seat, because it has brought U.S. interest rates lower than most on the planet, and in a world of single-digit returns, yield-hungry investors are looking elsewhere. Will it work? A weaker dollar is already starting to boost pricing power, thus helping the Fed fight deflation, it is bolstering profits and ultimately will spur economic growth.

Wait a minute, you might protest, the Fed isn't actively promoting a weaker dollar, they just got lucky that it's moving in the right direction. I politely beg to disagree. For the Fed, four dimensions of 'financial conditions' -- interest rates, stock prices, credit spreads and credit availability, and the dollar -- are the transmission mechanism that connects monetary policy to economic activity. Of course, the Fed only influences these asset prices indirectly, but when officials announce a policy commitment, they give investors a "put" back to the central bank. What my friend Paul McCulley at Pimco calls in this case the "Bernanke Put" -- the commitment to fight deflation -- is powerful. For example, I believe that a key part of the Fed's policy game plan has been to make risk-free assets very expensive -- so that investors will move out the credit spectrum to embrace risky assets and ease financial conditions. So far, so good, as credit and swap spreads have tightened dramatically in the past six months. Likewise, exploiting the fact that the textbook model of interest rate differentials is now driving currencies in a world of single-digit returns, the Fed has gained another degree of policy freedom by making dollar-denominated fixed-income assets less attractive. Just as the Fed used dollar strength in its fight against inflation, it is now using dollar weakness in its fight against deflation.
Source: Morgan Stanley Global Economic Forum
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