Wednesday, July 2, 2008

The Dollar: the Next Six Months

The last six months was not one of the best for the United States Dollar. The value of the dollar declined by about 7.5% against the Euro; 1.3% against the British Pound; and around 3.5% against an index published by the Federal Reserve System, an index relative to currencies in a broad group of major U. S. trading partners. During this period United States policymakers were focused primarily upon a liquidity crisis that hit full force in March and resulted in an assisted merger transaction and weakness in the domestic economy. The Federal Reserve and the U. S. Treasury Department were continually putting out fires here and there and providing liquidity to securities dealers and investment bankers. The first half of 2008 was not a time these policy makers could pay much attention to the decline in the value of the dollar.

What is the outlook for the next six months?

In my view, the outlook for the value of the United States Dollar over the next six months is not a good one. There are just too many things now in the works that do not favor an emphasis on a strong dollar. The question is, however, whether or not these possibilities are already incorporated in the current value of the dollar? My best guess is that the dollar will remain weak during this time period and will drift lower as more and more information reaches the market concerning the problems the world and the United States are facing.

The first such event on the horizon relates to the possibility that the European Central Bank will raise its base interest rate to combat the inflation that has now spread across Europe and that is twice the level of the ECB’s target rate of inflation. Moving this interest rate will put more pressure on the U. S. Dollar because the Federal Reserve is not expected to raise its target rate of interest due to the weakness of the U. S. economy and it financial institutions. There is also the possibility that central banks throughout the world will be raising their interest rates during the summer or fall months.

This possibility points up a real problem in world financial markets: the ECB, for example, is charged with one objective…to keep inflation under control. Its charter makes it completely independent of the political structure in the European Union. Thus, the ECB can pursue its objective of keeping inflation under control without immediate fear of political consequences.

Due to the independence of the ECB and many other central banks throughout the world, inflation targeting can be the sole focus of these organizations. This contrasts with the goals and objectives of the Federal Reserve System in that the Fed has two objectives it must focus upon…inflation and economic growth. These goals are not always compatible. Furthermore, if nations are “out-of-sync” economically with one another, as the United States seems to be “out-of-sync” with much of the rest of the world, then playing by different rules creates major national conflicts.

The possibility of conflicts, like the current one, is seemingly going to be an issue to be debated in the future. The French president Nicolas Sarkozy has already raised the issue of independent central banks and the problem of focusing on just one goal…inflation. (See the article in the Financial Times, “Elysee attacks ‘misguided’ policy of ECB”, This is the problem that ‘politicians’ always have with independent central banks and it represents the reason why central banks need to be independent of their governments. The current times are going to be ripe for political attacks on this independence. But, any such debate will not be a confidence builder for the support of strong currencies.

There are several other factors that will be hanging over the foreign exchange market over the next six months. Perhaps the most important one is the influence, or, one could argue the lack of influence, the current administration will have on the economy and the financial markets should a crisis arise. There is only one thing, in my view, that the Bush administration can pursue aggressively in the last few months it is in office…it can aggressively move to prevent further financial collapse or economic dislocation. This is the only thing the United States Congress will allow the Bush policy makers to do. Anything of a more positive nature will be postponed…like the efforts of the Treasury Department and the SEC to coordinate and share data collection. The Democratically controlled Congress expects to see a Democratic President seated in January 2009 and also expects to hold greater majorities in both the Senate and the
House. They are not going to allow this administration to initiate anything in its last few months in office.

Administration policymakers are very much in a dilemma. We have recently heard Fed Chairman Bernanke and Treasury Secretary Paulson speak about supporting a strong dollar. Paulson “reaffirmed the importance of a strong dollar” in Europe yesterday. (See “Paulson, in Europe, Finds Misery Loves Company”,
Neither really have the option of doing anything about it at this time except talk. Furthermore, raising interest rates over the next four months and causing greater financial distress and economic misery would only make it more difficult for a Republican to be elected in the fall. So much for central bank independence.

The economy is also going through its adjustments and there are many uncertainties connected with how strong or weak the economy will be. On one hand, the United States economy has stayed stronger than expected through June of this year…but there is plenty of evidence that events over the next six to eighteen months may be rather unpleasant ones, especially for workers and businesses, both large and small. We are only beginning to see the impact that the higher price of oil is going to have on the economy. The auto industry is reeling…airlines are facing huge problems…retail trade is suffering…financial institutions are not out of the clear (there is great concern over the condition of regional and smaller banks for example)…and there is still the housing industry. What this is going to do to labor markets and workers and families is still to be determined. (For an interesting take on this see “Dispelling the Myths of Summer”,

The uncertainty with respect to how the economy is going to evolve connected with the inability of the “lame duck” administration to do much of anything leaves the candidates for president in an awkward position. The state of the economy is certainly going to have an impact on the election, but the issue is, what approach to projected policies should the candidates take? Right now the candidates are presenting programs representing what they would do if they are elected president…and the economy were not a problem. We are hearing nothing about what they would do if the economy is not in very good shape…or if the economy is “in the tank.” We have no idea who they would install as cabinet members or advisors. As a consequence, we have no idea about how either candidate would respond to the issues now facing the financial world over the value of the dollar.

Thus, the outlook for the dollar over the next six months is for little or no support to come from the United States government. And, with no insight as to how a next presidential administration would respond to the dollar situation there can be little or no confidence as to whether the dollar would be supported in the future. I don’t see how one can attach any confidence at this time to a sustained near term recovery in the value of the dollar.


Transformers said...
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GS751 said...

I saw your post on seeking alpha and agree with most of your thesis. I hope you don't mind but I added you too my list of blogs that I read. I am tired of the WSJ and other people getting prices and inflation mixed up.

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