The Fed's Desired 'Weaker Dollar'

A: Fed cut 50 basis points yesterday and until the last five minutes of trading, the markets enjoyed it. Why not right? Now, I have been in the camp of rate cuts for about 4 months now, once the commodity bubble started to roll over showing the true strength of deflationary forces. Deflationary forces also sparked a dollar rally, bringing a reversal to long-held carry trades and 'short dollar/long euro/pound' trades. But does the fed really want a stronger dollar? In my opinion, NO WAY! It's nice to have some national pride and desire a stronger dollar, but if the dollar continues on its fierce upward trajectory, it will do more harm than good and hurt large multinational corporations who depend on currency trends to boost the revenue effect of foreign business, IBM is a great example. Ben's trying to inflate us out of this deflationary spiral, and a weaker dollar at this stage is probably desired.

In regards to the moves the dollar has made, think of it as a wrestling match and lets call it DEFLATIONARY FORCES vs FED & TREASURY TAG TEAM.

Deflation is causing the dollar to rise, but Ben & Hank want to inflate and that means debasing the dollar; after all if they wanted a strong dollar they wouldn't be cutting rates so aggressively now would they? Any strong dollar talk from this fed or treasury, in my opinion is BS! If dollar strength continues at this rate, more harm will be done and its clear the fed will do everything to inflate, and that means trying to debase the dollar or at least stop its sharp upward movements.

Deflation is the worst outcome, unfortunately its already here. The fed will take a little bit of inflation later, if it means getting us out of this deflationary spiral in the near future. While housing and credit contract, are prices everywhere going down though? Econbrowser debates whether general deflation is here:

"In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you're sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills."

That is what they are doing. If you don't believe this, just look at all the facilities the fed has taken on, trying to liquidate the market, and how much money was poured into bailing out those institutions deemed too big & too interconnected to fail. The fed's balance sheet doubled from a year ago, according to this Forbes story:

According to the Fed's H.4.1 releases, as of Thursday, Oct. 23, the Fed's assets totaled $1,804,208,000, roughly double its total of $919,235 a year earlier. Bank reserve balances during the same period rose from $294,225,000 to $301,270,000, an increase of only 2.4%. Thus the monetary impact of Fed activities over the year has been substantially less than implied by the doubling of its assets.

One could easily argue that the Fed overdid its sterilization for most of the period, which made monetary policy too tight. As for the recent period, the extremely high growth is probably appropriate, and not inflationary, while credit markets remain frozen and velocity continues to fall. It is something that will have to be corrected as we return to normal in credit markets, or accelerating inflation will become a serious concern.

Corrected, as in, weaning the banking system off all these lending facilities. Yes, that is in our future, the only question is when. Below is the latest figures for the Fed's expanded balance sheet as of Oct. 23rd, via federalreserve.gov:

For now, all attempts are on inflating to kill the deflationary monster. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke signaled he's ready to cut interest rates to the lowest level on record should the central bank's actions fail to stem the deepening economic slump.

Bernanke is drawing on an academic career studying the failed efforts to prevent the Great Depression, and yesterday's shift indicates he's prepared to revisit his 2003 commitment as a governor to lower rates to zero percent if necessary. Should lending fail to revive by December, the central bank will probably cut by another half point, said former Fed Governor Lyle Gramley.

Will they be successful? Will the dollar stop rallying with the fierce moves it has in the past few months? Will the fed stop deflation, and contain the inflationary side effects down the road? For me, this type of success is impossible. I'm not making predictions, I'm just saying that a weaker dollar is a side effect of inflation, and it's inflation the fed is trying to accomplish here.

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