The Federal Reserve Chairman is chatting up the dollar these days. On two separate occasions this week, Ben Bernanke made some extraordinary comments about inflation and the greenback. That is extraordinary for a sitting Fed chairman.
Typically, the tired remarks about a strong dollar being in the best interests of the U.S. are dispatched by the Treasury Secretary—a view that's summarily dismissed by forex traders largely because it's been made so often over the years that it's lost any real meaning. But when the Fed chairman speaks of the buck with a bullish view, well, that's something else entirely. Unsurprisingly, the foreign exchange market is paying attention.
On Tuesday, June 3, Bernanke talked directly about inflation and the dollar, a rare and therefore refreshing event in the history of Fed head chatter over the past 20 years.
In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.
He later went on to say that, over time,
the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy - including flexible markets and robust innovation and productivity - will be key factors ensuring that the dollar remains a strong and stable currency.
But let's not kid ourselves. Bernanke's comments were hardly an economic epiphany. If the chief economist of a large Wall Street bank had uttered the points above, the audience would have nodded in agreement and moved on. But when the chief of the world's most important central bank makes these kind of statements, it's news, in part because such clarity from the Fed chief on these matters is usually MIA.
The clarity was repeated the next day, when Ben spoke at Harvard, his alma mater.
If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly.
Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve. We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.
It's no coincidence that the dollar has been rising this week. Some of this can be attributed to Bernanke's commentary, which basically boils down to advising the markets that the Fed is alert to the dollar's weakness of late and the modest rise in inflation. The implied message: the central bank will do what's necessary when, and if, it feels compelled to act in the defense of the greenback.
In fact, there's more than jawboning behind the dollar's rise, namely: rising expectations that the Fed's rate cuts are over for this cycle, as we discussed back in late April. Since then, the market for Fed funds futures has decided that the Fed's 25-basis-point cut to 2.0% Fed funds on April 30 will stand as the low point for the foreseeable future.
It's that change in expectations that's largely responsible for driving the dollar higher. The Bernanke comments are helping, of course, but it's the view that rate cuts are now history that has swayed the forex market. But here's where it gets tricky.
If rate cuts are over, it's because the outlook for the economy is improving, or at least no longer deteriorating. Alternatively, the Fed expects inflationary momentum to continue bubbling. Or perhaps both apply. In any case, the notion of further rate cuts is now a minority view. It's not clear that the Fed's going to start raising interest rates any time soon, although Bernanke's hand may be forced if the dollar resumes its fall. Indeed, a threat is only as good as the willingness to carry out the action, which in this case amounts to raising rates. Is that possible? Is it likely?
Words, in short, can be potent tools in the forex market, but only in the short run. Over time, traders respect only actions. It would do the Fed's credibility no good if the dollar takes up its old habit of recent years and plumbs new lows. In that case, the central bank would be forced to raise rates to avoid losing face, or otherwise wave the white flag and effectively admit that its verbal forays into talking up the buck were a failure. Quite frankly, the Fed can't afford that kind of a credibility loss at this stage and so logic suggests it won't happen.
Then again, it's possible that a coordinated intervention by the world's central banks could prop up the dollar without a change in rates directly. But that too comes with risks in the current environment, starting with the fact that the markets might see it as a desperate act.
But for the moment, Bernanke and company have scored a tactical victory. As we wrote this, this dollar was inching higher again. It would come as no surprise to see the dollar rally in coming days, or perhaps even weeks. But it's still too early to know if a fundamental turnaround is brewing. Eventually, the economic trends define outcomes. In the short run, however, anything's possible.