Discounting the FED and the dollar

The central banker event risk for this week was highlighted by the FOMC decision on Tuesday afternoon. Predictably they did not make any changes to the actual fed funds or discount rate but the subsequent press release did make their intent rather clear. A quick read of the communique reveals that most of the language used this time was very similar to what was used in the August release with the notable exception being the change in the wording of this one phrase.
  • August 2010:“the committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability”
  • September 2010: “the committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”
The only conclusion that one can glean from this is that the FED is extremely worried about the current state of the economy which, if not addressed promptly, could result in the US getting mired in a deflationary spiral. With this looming over their heads they seem resigned to the fact that they will have to inflate the economy by, once again, opening up the monetary printing presses, a process that the bond markets have been discounting for a while. Obviously with an increase in supply, the value of the US dollar will have to decline which would have the intended effect of reducing the true value of our debts. All that remains now is the timing of this act. The FED is probably loathe to officially embark down this path until they get more data points and until the mid-term elections are over, but if the economy continues to under-perform then Novembers’ FOMC would be the likely launch date for QEII. Given the above scenario it is quite possible that the markets discounting mechanism could translate into a fairly rapid dollar free-fall leading up to that meeting.
There are, of course, several factors that could derail or, at the very least, slow down this event. Chief amongst them would be if the US economy stages a miraculous turn-around and all this talk about QEII becomes moot or if some financial crisis gives rise to another bout risk aversion. China might not be too keen to see their dollar investments lose intrinsic value, but given that unloading their holdings is unrealistic and given the criticism they have received for their manipulation of the Yuan to gain an edge in the international trade arena, their objections might fall on deaf ears. Aside from some political rhetoric they will probably have to resort to surreptitious interventions in the markets to try and stem a precipitous fall as they diversify their portfolio. Another major concern would be Europe as the ECB might not be too thrilled with a sharp appreciation of their currency but it would seem that, at least for now, their economic prospects don’t portend to be as anemic as ours and a stronger currency would have the effect of curtailing inflation(always a worry for them) to a certain degree.

The FED appears to be on the precipice of embarking on a weak dollar policy to try and inflate the US economy back to recovery. There might be protests from some in the international community, but if one were to evoke the fundamental truism that the health of the US economy is of paramount importance to the global economy then one might have to accept the dollars’ weakness as a fait accompli.

Akhilesh S. Ganti
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