Tuesday, June 10, 2008

With a Little Help From My Friends

From my latest market update:

It appears now as well that the mandarins of the Federal Reserve have finally discovered that a weak dollar may be complicating their policy making. Ben Bernanke delivered a speech recently where he acknowledged, finally, that the falling dollar was having an effect on inflation and pledged to make it part of their future deliberations. The dollar is part of the Treasury Department portfolio and previous Fed Chairmen have assiduously avoided speaking about the value of the dollar lest they step on the wrong toes. That Bernanke even mentioned the dollar tells me that he and Hank Paulson are of a single mind about the future course of the dollar. Don’t be surprised if you see a report soon about the Treasury buying dollars on the open market. Coordination between the Fed and the Treasury could cause a lot of heartburn for speculators who are almost universally short the dollar.

A lot of the effect from that speech was wiped out by Trichet's comments late last week. Today, there was an obvious coordinated message about the dollar coming from the administration, maybe for the first time. Bush talked about the dollar before leaving for Europe and again in an interview:

President Bush talked up the dollar's prowess Monday before leaving on a trip to Europe, saying "long-term strength" of the U.S. economy would be reflected in the currency. Later in the day he went even further, telling the Times of London in an interview that "we want the dollar to strengthen." Treasury Secretary Henry Paulson, meanwhile, refused to rule out intervening in the markets to prop up the flagging currency.

The comments boosted the dollar, which bought 106.30 yen, up from 105 yen Friday, and the euro fell to $1.5628 from $1.5769.

Later Treasury Secretary Paulson was asked about intervening in currency markets to support the dollar:

Mr. Paulson also bolstered the dollar when he said he wouldn't rule out another tool in the administration's limited arsenal: Intervening in the markets by coordinating with other countries to buy dollars in foreign-exchange markets. "I would never take intervention off the table or any policy tool off the table," Mr. Paulson said, replying to a question about intervention in an interview with CNBC. "I just can't speculate about what we will or won't do."

That may not seem significant but until now, the standard line about the value of the dollar from the administration has been that the market should determine the value.

Then tonight Ben Bernanke sounded fairly positive about the economic outlook in a speech about analyzing inflation:

Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.

To translate: The economy is not that bad and will likely improve from here. Don't expect any more rate cuts.

Bernanke then turned to inflation:

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities. Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand. However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention. Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Translating again: Inflation is too damn high and its freaking me out a little. I hope it gets better but after watching crude bounce around in a nearly $20 range last week, frankly, I don't have a clue. And if it doesn't come down, we will raise rates.

The dollar was up signficantly against the Euro today; we'll have to see if there is any carryover buying tomorrow after Bernanke's speech tonight. It appears to me that Bernanke and Paulson are working together. If Paulson, who came from Goldman Sachs, is as savvy a trader as Rubin was, he wants to wait until he's got the dollar going in the right direction before intervening in the market. And if he can spark a rally by just talking, he may not have to intevene at all. I'm not sure just talking will be enough so I still expect to see the Treasury in the market buying dollars for euros at some point soon. If Paulson builds up that expectation and then doesn't follow through, the whole strategy could backfire.

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