Perhaps it was just bad timing, or dumb luck. Or maybe the forex market really is testing the Fed chairman. Whatever the explanation, Ben Bernanke's decision last week to break with precedent and talk up the dollar looks ill-timed.
But what's done is done. As we discussed last week, the Fed chief last Tuesday and Wednesday decided to speak in relatively clear and transparent terms on the dollar and inflation. By the standards of former central bank heads, Bernanke's chatter was surprisingly transparent, especially as it relates to the dollar. Typically, talking about a strong dollar is left to the Treasury Secretary for public discussion. But last week was different, and Bernanke said in no uncertain terms that the Fed's "commitment to both price stability and maximum sustainable employment...will be key factors ensuring that the dollar remains a strong and stable currency."
Extraordinary as such comments are for a Fed chairman, the effort backfired, judging by last week's fall in the dollar. The U.S. Dollar Index fell by nearly 1% last week, with all of the decline coming on Thursday and Friday, i.e., the two days immediately following Bernanke's remarks on the dollar. Of course, it'd be naive to think that the greenback's stumble last week was purely a market referendum on Bernanke. There are many other global economic forces in play that conspired to trigger fresh selling in the dollar--higher oil prices and inflation worries, for example.
But let's be clear: if the dollar is allowed to decline for any length of time from here on out, the trend will take a toll on the Fed's influence. Yes, the central bank's primary weapon is the power to control the money supply, and by extension the price of money. But moral suasion is also a critical lever for the Fed. Simply put, what the Fed says is no less important than what the Fed does. In the cause of central banking, actions don't speak louder than words; rather, the two are on equal footing. A central bank that loses the respect of markets is a central bank that must wage its fight for sound money with one hand tied behind its back.
Ideally, a central bank will avoid backing itself into a corner in which it must wield the monetary weapon more forcefully to convince the markets that it won't waver in defense of its currency. The question now is whether the Fed is in this proverbial corner? If so, will it feel compelled to act by raising rates? It's too early to tell, although this week may be revealing, depending on what unfolds.
As it stands on Monday morning, it's clear that Bernanke and company have their work cut out for them. First and foremost is the task of convincing the markets that the Fed's words are more than just idle chatter of no consequence. Having set a new standard in Fedspeak via his comments last week, Bernanke is now under pressure to prove that his public comments have significance in the world of foreign exchange.
Unfortunately, supplying proof won't be easy in a global economy swirling with change and risk. But it was Bernanke who chose to speak as he did last week, and so he's created a bigger challenge. Perhaps he should have delayed his comments until the dollar was more likely to stabilize. Then again, a coordinated policy of dollar support engineered by the major central banks may be imminent. Or, possibly the Fed will hike interest rates to reconquer the high ground. Meantime, there's always the possibility that a new era of dollar strength, or at least stability, is about to begin sans intervention from the institution that prints the currency.
In any case, it's clear that if the dollar continues slipping from here on out, without so much as a peep from the Fed, the trend won't do Bernanke and company any good. And the threat couldn't come at a worse time. Even under the best of circumstances, central banking in 2008 faces some of its toughest challenges in decades. Alas, these aren't the best of circumstances.