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Paulson's Dollar Bluff


Like Fed statement on inflation, comments on intervention designed to buy more time.


Financial journalists seem to be pretty excited about the prospects for intervention to support the dollar, but how realistic is this or the idea that a couple rate hikes from the Federal Reserve are enough to crush inflation?

When asked about the U.S. possibly intervening to support the dollar, the Treasury's Henry Paulson said it was "never off the table." When asked the same question later in the day, the Federal Reserve's Richard Fisher said, "I watched the Paulson interview. I'll leave it as it was. You never take anything off the table. The key thing is to get our own house in order."

Notice how Fisher wasn't as aggressive on the intervention front as Paulson and focused more on getting "our own house in order." That's probably because Fisher knows the only lever the U.S. has to support the dollar is interest rates, which can't rise until the banking system and economy are righted.

As I'm sure Paulson well knows, (in my opinion he's just bluffing like the rest of them) the U.S. has no foreign currency reserves to speak of with which to intervene even if it wanted to (other than gold). That's what happens when you run a record trade and current account deficit year after year, but it's never really mattered before since the U.S. dollar was the world's reserve currency. That's where today's situation is somewhat different from any other post-1980.

Today, the only way the U.S. can intervene in the currency markets is if foreign central banks intervene for them and support the dollar by "printing up" their own currency and buying dollars (or through swaps allowing the U.S. to do so). Either way, foreign central banks have to be willing to accept more of the inflationary burden for them to do this, since their currency would weaken against the dollar. However, inflation would remain the same and therefore worsen from the foreign central bank's standpoint due to their own currency's depreciation vs. the dollar.

In the case of the ECB, it clearly doesn't want to carry more of the inflationary burden for the U.S. and won't be riding to the rescue to push down the euro anytime soon, even though it would clearly prefer the euro to be weaker for trade reasons as long as it was combined with lower inflation. But when given the choice, the ECB clearly appears to have chosen fighting inflation over favoring growth via a weaker euro in its most recent statement, and that means the euro is going higher, given that the U.S. cannot follow with rate hikes of its own.

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These statements by Paulson regarding intervention amount to a giant bluff, and like the Fed's comments about inflation, they are merely designed to buy more time by trying to prevent the dollar's decline from becoming disorderly. Talk will only go so far, however.

The same can be said for "Gentle Ben" Bernanke's "tough guy" comments last night on inflation as well. After all, this guy has been talking tough against inflation every meeting since he began easing in September. Now the market is finally forcing him to raise the volume of the rhetoric somewhat by pushing oil to levels that six months ago would have been beyond the wildest dreams of most.

There's no doubt that the Fed will eventually be raising interest rates at some point, but it won't be until the banking system is in better shape. And even then, the creep higher in interest rates that the Fed is likely to undertake will remain well below the rising rate of inflation for some time (i.e.- real rates will still be negative even as the Fed is raising rates). Even the Fed's Fisher, the supposed "hawk," said today that any future rise in interest rates would be "very deliberate'' and "gradual."

This Fed bluff against inflation is no different than Paulson's intervention bluff on the dollar. yes, the Fed will eventually be raising rates, but by the time it does, it will be so far behind the curve that it won't matter much.

As I've noted before, it was after the dollar index bottomed in 1978 that inflation really accelerated during that particular stagflationary period. It was also after that low in the dollar index and after Volcker began raising interest rates that gold went up four-fold too. The Fed's first rate hike is not the signal of the end of inflation. Instead, it's typically the signal that inflation is about accelerate. Monetary policy works with a lag after all.

The Fed has been quite successful at running the printing press and cushioning the housing bust and the resulting credit crunch, but the price of that "printing" is going to be more inflation. There are no free lunches.

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