With the recent retreat in the price of gold and oil, the Goldilocks community has been quick to predict a return to the days of a “strong dollar”. And with even Ben Bernanke acknowledging the link between a weak dollar and rising inflation (a direct contrast to his last year’s position that a “weak dollar does not affect US domestic prices”), and his tough pronouncements of “ensuring that the dollar remains a strong, stable currency”, readers might be tempted into thinking that we are set for a dollar rebound.
Not quite though. We need to put recent events in perspective. Gold had moved from a little more than $250 to more than $1,000 per ounce, oil from less than $20 to more than $135 a barrel and the dollar index from 120 to 70 — all in the last six years or so.
Under the circumstances, the occasional dollar short-covering rally is not unusual. Regarding the tough talk of Bernanke, readers need to remember that Paul Volcker didn’t build his reputation by talking tough, but by acting tough. Volcker raised interest rates to 22% and had dramatically reduced money supply growth to quell the high inflation of the 1970s.
Before we speculate whether Bernanke has the stomach to make such a move, we need to analyse the fundamental factors that have resulted in the loss of purchasing power of the dollar. The main reasons are a rapid expansion in the supply of money, negative savings rate of US consumers and a ballooning trade deficit as a result of the borrow-and-spend economic system in place there.
In terms of all the three factors mentioned above, the US is perhaps in a worse state compared with the past. The US Fed continues to expand money supply (growth in M3 as measured by private sources is about 17% today) at a record pace, the savings rate in the US continues to be negative and despite the significant decline in dollar exchange rates with other currencies, the US trade deficit continues to remain at record levels (for the first quarter of 2008, it was $178.8 billion compared with the first quarter of 2007 at $178.5 billion).
How about the fiscal initiatives and other policy actions that would restore some confidence in the dollar? The US government continues to encourage consumers to spend, as was witnessed through the recent $100 billion tax rebate cheques. The Fed, on its part, tries to throttle the free market — that would help deflate the housing bubble — by bailing out troubled investment banks and mortgage lenders with tax-payers’ money. As if such interventions were not enough, the Fed has now announced that it will take on credit card receivables, auto loans and student loans as collateral. US interest rates continue to languish well below even the official consumer price inflation numbers, resulting in negative real interest rates. For the US consumer, who has been inclined to spend rather than save, negative real interest rates provide very little incentive to change course.
Therefore, nothing really has changed on the ground — either in terms of policy initiatives that would signal a return to a more sustainable and free-market oriented economic system, or in terms of numbers that would imply a turnaround from the forces that has been the cause of the dollar weakness.
It will, however, be interesting to speculate what the next moves of the US Fed would be. For reasons beyond pure financial returns, the long-term bond yields in the US have followed the US fed funds rate during the recent rate cuts. But with inflation at the current levels, it is only a matter of time before these long-term yields begin to shoot up, irrespective of the decision of the Fed regarding interest rates.
Under those circumstances, and in spite of the faltering economy and a continued downturn in the housing market, Bernanke would be forced to hike interest rates to restore a semblance of stability to the dollar. But, as explained, the problems are much too structural and all that the Fed can now do is to determine the extent of future declines of the dollar rather than prevent the decline itself.
How much further down does the dollar have to go? Much too far — both in terms of time and in terms of value. Over the next five years, and five years need not necessarily be the end of the dollar bear market, we could easily witness gold at $2,500-3,000 per ounce, oil at $300-350 a barrel and the dollar index at no more than 40. These numbers indicate the best-case scenario for the dollar, i.e., assuming that “Helicopter” Ben transforms himself into a “Volcker” Ben. In the very likely event of Bernanke not effecting such a transition, the targets given could well turn out to be gross underestimates of what is likely to happen.
Lest I end on such a morbid note, I think there might be a silver lining to the story after all. Hopefully, by the time the current dollar crisis ends, people would realize the folly of the unbacked fiat currency system that we have today and return to the gold standard, i.e., a market-based monetary system that prevailed before central banking was foisted upon the unsuspecting public.
Shanmuganathan N. is director at Benchmark Advisory Services. Comments are welcome at email@example.com