Tuesday, March 18, 2008

The last hurrah for the "strong dollar" policy

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability. FOMC

The Fed eased dramatically this afternoon, taking real rates, even using the lowest "official" measure of consumer inflation, the St. Louis Fed's median CPI, into negative territory.

You'd think that such an action would lead to a US$ sell-off. But it didn't. Toto, I've got a feeling we're not in Kansas anymore.

Despite lower rates, firmly negative against any measure of inflation, with even the Fed noting inflation has been elevated, the US$ rose, modestly against foreign currencies and strongly against Gold.

Why the substantial fall in the price of Gold? More selling than buying, as we used to quip on the trading desk.

"Why more selling than buying, smart A$$?," you might be retorting.

I have a few ideas.

1) The Sunday night melt up in Gold got the attention of finance officials, who either through jawboning or intervention, leaned on the price. The last thing those who wish to maintain the current system of exchange want is for Gold to rise dramatically with news of large financial firms going bust on the TV. As Kevin Bacon's character in Animal House put it, Remain Calm. All is well!

2) As one who has seen official intervention fail miserably, the point above is not sufficient, to my mind, to explain the decline. During a call with my friend Stephen Plant yesterday, I expressed my uneasiness, as a long term holder of Gold, with the rapid gains Gold had been making. Although I believe Gold is still dramatically undervalued here, it usually takes time for markets to adjust. Speculative froth creates its own restraining forces, and invites official responses, like increased margins for futures trading, et. al.

3) I suspect that part of the policy approach flowing from the recent meetings of the President's Working Group on Financial Markets is to flog the dead carcass of Bob Rubin's "strong $ policy." Yesterday, after briefing the President on the group's findings, Treasury Secretary Paulson, in response to a question about FX intervention had this to say:

We have a strong dollar policy. It's very much in our nation's interests.

Our economy has ups and downs. The long-term fundamentals -- and I'm very confident about this. When we look at our long-term fundamentals compared with other major countries around the world, we have strong long-term fundamentals. That will be reflected in our currency markets.

And so our whole focus here is on policies that are going to -- going to increase the confidence in our economy. And this is open trade, open investment, working through this capital market's turmoil in a way so that we minimize the impact on our economy.

4) tying the above points together, I suspect that the major banks are willing to see if the "strong $" narrative still holds water.

Over the short term, given the recent rapid advance before today, the narrative might gain credibility and Sorosian reflexivity might come into play.

Over the medium term, however, (and potentially even over the short term, and if so, Gold will really pop) I think this is the last hurrah for this approach. If, after the short term specs are flushed, the narrative begins to lose its magic, the Fed will have to get serious about defending the $ with more than jawboning and intervention. Having rapidly reduced rates deep into negative territory, with inflation rising, in sharp contrast to the post 9/11 easing, future capital gains on US bonds will be hard to come by. Reasons to buy the $ are becoming quite scarce.

As I see things, either the Fed realizes its error and gets in front of the market, which might keep the dollar decline somewhat graceful or the market begins to tighten for the Fed, and then the game is over, in a most ungraceful manner.

Either way, I don't think we'll be hearing too much more of the "strong $ policy" after the short term, except as part of some Daily Show/Colbert Report skit.

ps. I guess I was wrong in my earlier post. It appears the PWGFM still has a bit of mojo left.