The Fed and the Dollar

June 4, 2008

Fed officials are not supposed to speak publicly about the dollar, so when the Chairman devotes a four-sentence, 150-word paragraph to the perils of excessive dollar depreciation, you can bet the ranch that prior approval for Bernanke’s comments was secured from the highest reaches of the Treasury Department. By law, the Treasury Secretary is responsible for U.S. foreign exchange policy, determining what is said about the dollar and when to intervene in currency markets. The Fed’s role in all of this is as advisor and agent, not ultimate decider. But I cannot recall a time when a Treasury official spoke as extensively about the dollar as Bernanke just did. The strong-dollar mantra introduced by former Treasury Secretary Robert Rubin attested that a strong dollar is in the best interest of the United States because it promoted low interest rates, low inflation and capital inflows. At the time, CPI inflation was running around 3.0%, but it was not accelerating and evoked less concern than at present.

The closest historical parallel to Bernanke’s verbal intervention that I can recall was the rescue package announced November 1, 1978. Quoting from the New York Federal Reserve Bank Quarterly Review Spring 1979 issue, on that day, “President Carter, the United States Treasury, and the Federal Reserve announced a series of actions to correct what had become an excesssive decline of the United States dollar in the exchange market. …The November 1 program, developed in close cooperation with governments and central banks of three major foreign countries, was linked closely to the broader anti-inflation policies of the United States Government. It featured a further tightening of monetary policy, including a 1 percentage point increase in the Federal Reserve discount rate to a historic high of 9.5%.” Tying dollar support to price stability was a novel thought at the time. Just a year earlier, an internal research project had been commissioned at the FRBNY to disprove the vicious circle hypothesis that accelerating inflation and dollar depreciation were reinforcing one another. In the end, the study suggested otherwise. The Fed had never raised interest rates by as much as 100 basis points at one time, and neither before that time nor since then has an interest rate change been motivated and justified primarily by developments surrounding the dollar.

Bernanke’s remarks, which can be found in the third from final paragraph of a speech he delivered by satellite to an international monetary conference in Barcelona, Spain, have their roots in the November 1978 rescue of the dollar. The first sentence leads off with “in collaboration with our colleagues at the Treasury…,” leaving no doubt that the Chairman is not a loose cannon here but rather the designated spokeman for verbalizing an escalated defense of the dollar. Sentence two gets right to the point, asserting that downward pressure on the dollar has “contributed to the unwelcome rise in import prices and consumer price inflation.” The third sentence promises to address both policy mandates in the future, price stability as well as maximum sustainable employment, and states that dollar depreciation could erode longer-term inflation expectations. The final sentence reiterates Treasury Secretary Paulson’s oft-repeated projection that dollar strength and stability will surface in the long run because U.S. longer-term fundamentals are good. To leave no ambiguity on this point, Bernanke identifies these strengths: flexible markets, robust innovation and productivity, and a credible Fed commitment to price stability.

The paragraph suggests that a point of inflection has been passed in U.S. monetary policy. Some analysts expect a double-dip slowdown in U.S. growth after the tax rebates pass and are predicting that more rate cuts will occur later this year. From where I sit, doing that would be an enormous abandonment of Bernanke’s rededicated promise to protect the dollar. The dollar would be served better in that case if Bernanke had not spoken about it today. Although the Fed did not raise interest rates now, the Chairman seems to imply that either an undue further rise in inflation or a failure of such to settle back within the timetable that the central bank is anticipating will elicit higher interest rates.

The part of the paragraph that fails to hold up to the test of history is the link presented between long-term dollar strength and U.S. advantages in certain key economic fundamentals. Those advantages are not new, yet the long-term trend of the dollar against other key currencies like the D-mark/euro, Swiss franc, and Japanese yen has been unmistakenly downward since the late 1960’s when the old monetary system fixing currencies to the dollar and the dollar to gold came under uncontainable pressure and had to be abandoned.

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