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Bernanke and the dollar

In his first-ever press conference today following the FOMC meeting, Fed Chairman Bernanke mentioned the dollar quite a few times. You might think that would be a natural, coming from the head of the institution that has direct control over the supply of dollars to the world, and by extension the dollar's value. But in fact, the Fed rarely addresses the issue of the dollar's value in the context of the things it watches or tries to target.

So it was somewhat refreshing that today Bernanke joined with Geithner and Treasury Secretaries of the past in saying that a strong and stable dollar was in the interests of both the U.S. and the global economy. Unfortunately, he qualified that by adding that he thought the dollar's recent weakness was another one of those transitory things (like rising headline inflation and weak first quarter growth) that should reverse in the medium term. He's not targeting the dollar directly, in other words, believing instead that the dollar will find support and prove strong and stable over the long run if the Fed is successful at containing inflation and boosting the economy.

It's all too tautological for me, and for the markets, I suspect. Yes, if the Fed is successful in defending the dollar's purchasing power over time, then the dollar should find market support and its value should be relatively strong and stable. But just how are we going to get a stronger dollar tomorrow by weakening the dollar today?

As I've pointed out, the Fed has yet to commit any gross monetary error, since there is no sign of any unusual growth in the M2 money supply. But even though M2 is only growing at a a 6% rate, the decline in the dollar's value against other currencies and gold is prima facie evidence that the Fed is supplying more dollars to the world than the world is demanding. It's clear that monetary policy is accommodative, and that means the Fed is setting interest rates artificially low in order to create an over-supply of dollars, and an over-supply of dollars means the dollar's value has to decline.

This is what is troubling the world. How can we be sure that the Fed will be able to pull off the trick of weakening the dollar today in order to strengthen it tomorrow? A weaker dollar risks letting the inflation genie out of the bottle, and we know it's very hard to put back in once that happens. There is little or no theoretical or logical support for the idea that a weaker currency creates a stronger economy. Bernanke is saying the right things, but he is also asking us to trust him an awful lot. The world would feel much better if he were more specific. Holding press conferences is a good way to make the Fed more transparent, but unless there is substance (i.e., rules and/or objective measures that guide policy) behind the words, then fear, uncertainty and doubt will erode confidence in the dollar and that will exacerbate inflationary pressures. Less demand for dollars contributes to an over-supply of dollars the same way an increased supply does. In the end it's a negative feedback loop that threatens us all.

So it was not surprising to see the dollar decline in the wake of today's FOMC meeting (9:30 am Pacific Time on the chart above) and throughout Bernanke's testimony, and it was not surprising to see gold prices rise (see below). In nominal and real terms against a broad basket of currencies, the dollar is now at a new all-time low. In nominal terms gold is at a new all-time high, but in real terms it is still about one-third below the highs it (very) briefly reached in early 1980.

Ben "Trust Me" Bernanke may well pull off the greatest balancing act in history when all is said and done, but I have to believe there is an easier and more direct way to achieve a strong and stable dollar, which is ultimately the only way to enjoy low and stable inflation and a strong economy.

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