Bernanke's Bluff

Jawboning the Dollar will only prove cost-free until forex traders get over their shock...

BENJAMIN DISRAELI, the 19th century British prime minister, was once asked by a new member of parliament whether he should speak up on a controversial issue, writes Gary Dorsch of Global Money Trends...

   "Do you have anything to say that has not already been said?" Disraeli asked in reply.

   "No," the man conceded. "I just want the people whom I represent, and the other Members of Parliament, to know that I participated in the debate."

  
"Then it is better to remain silent," Disraeli concluded, "and have people say, 'I wonder what he's thinking?'...rather than to speak up and have people say, 'I wonder why he spoke'."

  
On 3rd June 2008, the super-dovish Federal Reserve chief Ben Bernanke couldn't remain silent any longer. He spoke up before an international television audience, and shocked the global money markets, when he commented for the first time on the need for the Fed to defend the US Dollar in the foreign exchange market.

  
"The Fed is working with the Treasury to carefully monitor developments in foreign exchange markets," Bernanke warned. "We are attentive to the changes in the value of the Dollar and inflation expectations.

  
"The Fed's commitment to price stability is a key factor, insuring that the Dollar remains a strong and stable currency. The possibility that commodity prices will continue to rise, and lift inflation expectations, are significant risks that might ultimately become self-confirming."

  
One week later, currency traders were left wondering if Bernanke had undergone a brain transplant, and come out re-programmed as a Bundesbank hawk, when he downplayed the biggest monthly surge in the US jobless rate in 22 years.

  
"The risk that the US economy has entered into a substantial downturn appears to have diminished. The FOMC will strongly resist an erosion of longer-term inflation expectations. There are significant upside risks for inflation through commodities," Bernanke declared.

  
Instinctively, foreign currency traders rushed to cover over-extended short positions in the Dollar, as yields on the US Treasury's two-year note jumped by a startling half-percent in just two days, discounting the likelihood of three quarter-point rate hikes from the Fed by year's end.

  
Something, clearly, must have changed to cause "Helicopter" Ben to suddenly talk about switching from inflating the US money supply at a 17% annualized rate – its fastest in history – to a more prudent course of defending the purchasing power of the Dollar.

  
But if "Helicopter" Ben is just bluffing about his determination to defend the US Dollar, then it would have been better had he remained silent last week.

   Foreign currency traders know the first line of defense for a currency in the $3.2 trillion per day forex market is "jawboning" – or trying to alter trader behavior and psychology with words alone.

  
Initially, these "open-mouth operations" are cost-free, and might even achieve the central bank's objective without more expensive remedies. But after the initial shock wears off, and if not backed up by concrete action, "jawboning" begins to lose its potency.

  
Unless the economic landscape changes, then before long, quick-trigger traders could test the resolve of the central bank, by attacking the beleaguered currency. Only nowadays, the Dollar's weakness against the Euro is also helping to elevate the agricultural and crude oil markets, as well as the Gold Price, and thus risking a major outbreak of hyper-inflation worldwide.

  
Consider that:

• the S&P Banking Sector Index has plunged to its lowest level in 12 years;
• US homes prices are sinking at their fastest clip since the Great Depression;
• Lehman Brother's stock (LEH) lost 54% of its value in the past four weeks.

   The Fed's ability to defend the Dollar with a tighter monetary policy is thus very limited. Just before Bernanke began his bluff, in fact, Sheila Bair – head of the Federal Deposit Insurance Corp. – warned that "weakening real estate markets could take down bigger banks than we have seen in the past," and would quickly exhaust the FDIC's paltry $58 billion cash reserves.

   Furthermore, the US jobless rate jumped a half-percent in May to 5.5%, its highest level in three and a half years. That underscores the big recessionary risks that the US economy still faces.

   Some 49,000 jobs were cut from payrolls in May, the fifth straight month of job losses, further sapping consumer confidence, already at a 16-year low. "Weak economic conditions could extend defaults on consumer installment or credit card loans, as well as corporate loan portfolios," as Fed deputy Donald Kohn warned.

   But the 2.0% Fed funds interest rate is still pegged far below the inflation rate – now well above 4.0% annually – and negative interest rates spawn speculation in the commodities markets, not least in Gold and oil.

   The US Dollar remains weak against the Euro, because the yield on the two-year US Treasury note is still roughly 180 basis points below the German two-year Schatz yield. A year ago, that two-year T-note was yielding some 60 basis points more than the German Schatz.

   On June 11th this year, St. Louis Fed chief James Bullard admitted the 2% Fed funds rate is too low and could fuel inflation, unless the Fed takes action going forward.

   "The Fed's easing in January and March was very sharp, for insurance against the possibility of a very bad outcome from the financial crisis. The probability of a very bad outcome from the financial crisis is now receding, and we've still got the low level of interest rates.

   "I see inflationary consequences of that going forward, if we don't take action and stay on top of this situation."

   Since the Fed began its easing campaign in August 2007, the year-over-year increase in the Dow Jones AIG Commodity Index has soared from -5.5% to a record +33% today, led by a near doubling in crude oil and grain prices, and pushing the global inflation rate to its highest in three decades.

   Yet until this month, the Bernanke Fed refused to weigh food and energy prices in its inflation calculations, and instead solely focused on bailing out Wall Street banks.

   So what cataclysmic event finally forced Mr Bernanke to publicly acknowledge the bankruptcy of his "core inflation" thesis, which strips food and energy out of the Fed's inflation equation?

   It was the stunning $16 per barrel surge in crude oil prices on June 5-6th – the surge that knocked the Dow Jones Industrials to a 400-points loss in a thunderous crash that rattled the US Treasury's "Plunge Protection Team".

   In a perfect storm, crude oil soared to $139 per barrel, supported by a 2.5% jump in the Euro to $1.5800 and comments by Israeli deputy prime-minister Shaul Mofaz, who said Israel's patience with Europe's reluctance to impose tough economic sanctions on Iran is wearing thin.

   Mofaz set the crude oil market ablaze when he told the Yedioth Ahronoth newspaper, "If Iran continues with its program for developing nuclear weapons, we will attack it. The sanctions are ineffective.

   "Attacking Iran, in order to stop its nuclear plans, will be unavoidable," he warned.

   Mofaz presented a sneak preview of what the crude oil and global stock markets might look like under the thumb of a nuclear-armed Iran. Whether an attack on Iran or a US naval blockade of its ports actually happens before President Bush leaves office is a matter of great debate and speculation. On June 10th, Bush warned, "If you were living in Israel, you'd be a little nervous, if a leader in your neighborhood announced that he'd like to destroy you. And one sure way of achieving that means, is through the development of a nuclear weapon.

   "Therefore, now is the time for all of us to work together to stop Iran," he said on his final tour of Europe. The next day, Bush indicated that all options are on the table in dealing with Iran.

   But behind the scenes, the Euro/Dollar exchange rate is also magnifying movements in the all-important crude oil market.

   "I'm very worried about the strength of the Dollar. We all know when the Dollar weakens, the price of oil goes up," said Republican presidential candidate John McCain in a June 10th interview on CNBC.

   It was the first time a key Washington politician acknowledged the link between the weak Dollar and the high price of crude oil, and by extension, other related markets that are soaring into the stratosphere, such as coal and corn futures.

   Yet as recently as May 28th, Minneapolis Fed chief Gary Stern cautioned against drawing a link between the Dollar's decline and lofty energy prices. "I'd be careful about mistaking correlation and causation. Just because energy prices and the dollar seem to move together, doesn't mean that there's causation there.

   "I would point to the rapid growth in China and India that has something to do with this," he said.

   Frederic Mishkin, a close confidant of Bernanke's, was still defending the central bank's practice of ignoring food and energy prices, too. "Stabilizing core inflation leads to better economic outcomes than stabilizing headline inflation. If central banks raise rates aggressively to counter inflation caused by a sudden rise in oil prices, unemployment will be markedly higher, than if policy-makers set borrowing costs in response to fluctuations in core prices.

   "When inflation expectations are well anchored, the central bank does not need to raise interest rates aggressively to keep inflation under control following an aggregate supply shock."

   Indeed, Bernanke appeared to be back-pedaling on his commitment to fight inflation when he tried to distance the Fed from using commodity prices to forecast to direction of inflation.

   "The poor record of commodity futures markets in forecasting the course of prices raises the question of whether policy-makers should continue to use this source of information," he said on June 9th.

   It will prove difficult to combat inflation if the Fed remains blind to the realities of the marketplace.

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