Is Dollar-Based Salvation Coming?

The hope that the troubling surge in inflation will soon pass draws on fresh hope born of the widely reported outlook for new-found strength in the dollar. And the hope doesn't come a moment too soon.

As we reported last week, the July report on consumer prices was sobering, one of the worst in recent memory. In particular, the upwardly mobile core rate of inflation suggests that inflationary pressures born of the bull market in commodities is now spilling over into other areas of the economy.

But that was last week. Many analysts are now expecting the dollar's reversal of late will come to the rescue. The assumption is that the dollar can keep climbing, or at least won't return to its bear market status any time soon.

One analyst spoke for many with a forecast that the formerly battered buck is headed for better days. "The fundamental picture for the dollar has improved substantially in recent weeks," Fiona Lake of Goldman Sachs told the Financial Times over the weekend. "As a result, we now think the dollar has bottomed."

Meanwhile, Forex Factory went so far as to label the rise in the euro vs. the dollar over the past several years as a "Euro bubble" that's in danger of popping. If so, that would be good news for the greenback.

And today's Wall Street Journal asserts that a rising dollar may be the silver bullet that ends inflation's grip for the current cycle. "The buck's rise," the Journal counsels, "should help quell domestic inflation by making imports and commodities cheaper."

Perhaps, although it'll take a month or two--or three or four--to find confirmation, or rejection, of the theory. Waiting for the next CPI report, in other words, promises to be a lengthy nail-biting run.

Meantime, it's hard to overlook the numbers. The fact that core CPI is now rising on a year-over-year basis may be dismissed by some, but for others it's a warning sign. Waiting and hoping that it will soon turn agreeable is, at least for the moment, asking a bit too much for some members of the dismal science. For example, Robert Dieli, who runs the economic consultancy Mr. Model, suggests that staying cautious on inflation's outlook is still prudent, a stance that will retain its appeal for at least another month. As he writes in a note to clients over the weekend,

The break to the upside of the change in the core rate removes what little cover the FOMC had to hold rates steady until the financial system could be brought back into better balance. While we don’t think this is going to provoke the hawks into open revolt, we do think it will embolden them to step up their calls for a rate increase and to add to the number of dissenting votes. The FOMC will get a fresh set of inflation numbers on the day they meet next month. If that report is as ugly as this one was the Committee will be hard pressed to issue another mild press release like the one that followed their August meeting.

Nonetheless, commodities prices are falling, and to the extent that the trend continues it will offer support to the dollar. Yet it's not yet clear that a stronger dollar alone will solve the inflation ills that harass the U.S. economy. Lower commodity prices and a stronger dollar are a powerful combination for battling inflation. A weakening economy will also help curtail pricing pressures. But the real question is whether the inflation sparked by surging commodity prices in recent years has spilled over into the wider economy, as the jump in core CPI suggests. Stay tuned.

Comments

[buyitcheap:]

You also had services inflation of .5% as well last month and then right after FNM and FRE get their bailout in the next few weeks... Well, what impact would a few hundred billion more newly printed US Dollars do to the currency value. Rates need to go up, but that will at best hold the dollar at these depressed levels. 75-78

2008 Aug 19 09:38 AM

[bearfund:]

There is absolutely no possibility that the Fed will raise rates. None. If you're buying dollars against forex because you expect US short-term rates to rise, you're in for a big disappointment. If you're buying them because you don't want to hold euros and yen (probably a smart move), let me remind you that gold is dirt cheap and cannot be printed to bail out Fannie and Freddie or drop from helicopters (dropping gold from helicopters would be a minor disaster in any case). The Fed does not care about prices of the goods and services that people and businesses need to live and operate. They care about the prices of the assets on their member banks' and now their own books. As long as those are falling, so will overnight rates.

I expect the Fed to cut rates again soon, possibly even before the end of the year, and my fed funds rate target bottom is 0.5%. My target for the 10-year Treasury note yield remains 10%. With each passing day, the disconnects and dislocations in the markets are growing more severe. Do not forget that the bear eventually hits everything. As the financial rot has worked its way toward the core, from hedge funds and SIVs to regional banks to investment banks to the Fed (whose balance sheet quality has declined perilously), the bear has ravaged homebuilders, mortgages, financials, telecom, energy, agency paper, and consumer discretionary. The rot is now knocking on the door of the heart of the system, the Treasury itself. Congress has given Paulson the legal ability to let it in, and when he does, the bear will enter as well.

2008 Aug 19 10:09 AM

[Lisa:]

Excellent article; thank you.

2008 Aug 20 02:13 AM

[NOWHEREMAN:]

Sabre Rattling will probably keep the dollar strong for a while longer. The US is removed from the immediate vicinity. But it is not removed from the potential effects of the conflict. Higher everything accross the Board.

Lets not forget the effects of the Minimum Wage on core inflation.

2008 Aug 20 11:44 AM