10.01.2008 0

Markets calling Bernanke’s bluff

  • On: 10/15/2008 11:14:55
  • In: Monetary Policy
  • Wed Jul 2, 2008 9:14am BST
    By James Saft

    LONDON (Reuters) – A surging oil price and a falling dollar show financial markets are giving short shrift to tough talk from Federal Reserve Chairman Ben Bernanke about fighting inflation and supporting the U.S. currency.

    Caught between a fragile economy and banking system and rising inflation — being stoked in part by negative real U.S. interest rates — Bernanke and the Fed seem to have arrived on a strategy of jawboning the dollar higher and inflation lower. And indeed, it would have been nice if it worked; the dollar is undoubtedly helping to drive oil prices higher and inflation fears can be soothed by faith in central banks.

    But talk is only effective if your audience judges that you have the means and the willingness to follow through. And when the Fed didn’t signal that it would soon tighten in its statement accompanying its June 25 decision to hold rates at 2 percent, that faith, expressed as market prices, began to drain away.

    “The dollar is the barometer for Fed credibility,” said Tim Bond, head of global asset allocation at Barclays Capital in London. “The dollar is going down and that says the Fed aren’t going to be doing their thing. Their credibility is low and will remain low until they show they are prepared to sacrifice growth (to fight) inflation.”

    The trade-weighted dollar index .DXY has slumped since the Fed’s decision, falling about 1.5 percent since June 24. It is also now below where it was when Bernanke, in a highly unusual move for a U.S. central banker, issued a warning about the inflationary impact of a weak dollar.

    That verbal intervention, coming as it did less than a week before the European Central Bank all but announced its intention to hike at its meeting July 3, looks in retrospect like a bit of insurance. Had Bernanke not talked up the dollar, it would very likely have fallen rapidly, and perhaps in a disorderly way, when three days later ECB chief Jean-Claude Trichet effectively flagged his resolve to raise rates.

    And having spoken about the dollar and gained only a short respite, it will be interesting to see if Bernanke broaches the subject again and how currency traders react when he does. Similarly, a chorus of hawkish comments from Fed officials, combined with a signs of continued but weak growth, transformed expectations about the path of interest rates in May and June. A lack of follow through from the Fed has weakened those expectations again.

    U.S. short term interest rate futures now imply a roughly 50:50 chance that the Fed will stay on hold when next it meets in August, as against June 24 market pricing that placed a 74 percent probability on them hiking by 25 basis points.


    Things have not been helped by a new round of market weakness and credit jitters, as the reality dawns that rebuilding the capital of the banking system will be a long process with quite a few casualties.

    This has not only hit equities, it has also served to underline the difficulties facing the U.S. central bank. It would be very hard to support the dollar, not to mention raise interest rates, if banks or brokers are failing.

    The further rise in the price of oil is also a sign that at least some in markets doubt the will of the Fed to fight inflation. U.S. light crude CLc1 has risen to over $140 a barrel, as compared with about $135 before the Fed held rates and about $125 when Bernanke fired his dollar salvo.

    Bernanke is thought in part to have jawboned the dollar upward because a falling dollar tends to drive oil prices, and the inflation they bring, higher. But fundamentally, demand for oil is being driven by the very high rise in demand from emerging economies, especially China. That demand, and inflation in the emerging world, is being stoked by a U.S. interest rate that is much lower than the rate of inflation.

    The Fed is setting monetary policy for the United States, not for China, but lives in a world where China now drives inflation in the United States. From that point of view, the surge in oil is a bet against the Fed hiking interest rates and doing the job of the Chinese central bank for it.

    But the United States is not in good shape. Housing is a disaster, credit will only get tighter and the effect of tax rebates will ebb as the summer unfolds. It may simply not be in a position to withstand higher rates.

    If so, look for a falling dollar and rising oil.

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