If you’re wondering why Fed Chairman Ben Bernanke is being cagey when it comes to discussing when and if interest rate hikes will end, and for how long, take a look at the dollar.
The almighty greenback looks something less than invincible these days. The U.S. Dollar Index is off by roughly 5% from mid-March. The decline was unfolding for much of April, although the sellers found inspiration anew after Mr. Bernanke’s suggestion last week–ever so carefully worded–that the central bank’s rate hikes of the last two years may pause, if only temporarily, at some point in the near future.
As we wrote on Friday, this “new transparency” from the Fed chief isn’t quite the epitome of the clarity that Bernanke has formerly embraced as the ideal for the central bank. To read his speeches of years past one would think the man atop the central bank would settle for nothing less than unambiguous broadcasting on the matter of monetary policy. Then again, perhaps his subtle retreat from that position is unsurprising, considering the delicate balancing act Bernanke faces in navigating the increasingly rocky shoals of monetary policy in the months and years ahead.

On the one hand, there’s a strong argument that a continued squeezing of the money supply is necessary and essential for countering the inflationary forces that may be conspiring within the commodities bull market. The jump in oil prices in particular of recent vintage threatens to elevate inflation, if only marginally. As such, the Fed must counteract with monetary tightening. Yes, there’s debate about whether higher oil prices are the inflationary threat they were in the past. But with the economy continuing to show robust upward momentum, it may be prudent to err on the side of caution and assume that the oil-as-threat is alive and kicking if not yet fully proven in the 21st century.
Of course, there’s another view that the U.S. economy is set to slow, thereby taking away some of the inflationary winds that may or may not be blowing. True, this year’s first-quarter GDP report released last week seems to belie the case that the economy’s slowing. But economists say that the upward bounce in the nation’s output in the first three months of this year won’t be sustained at the 4.8% rate clocked in the first quarter. No, the economy’s not about to contract any time soon, but even a slowing in the second quarter to, say, 3.5% from 4.8% would help take some of the wind out of inflation’s sail.
Both of these scenarios have merit–thus Bernanke’s conundrum on interest rates. Continuing to hike Fed funds risks giving momentum to a slowdown that would arguably gather steam as the year unfolds. It’s never popular to have a central bank engineering economic slowdowns, but doing so at this juncture could hardly be more fraught with risk. There’s no shortage of criticism that the expansion of recent years hasn’t trickled down to the working class. Meanwhile, with anxiety about globalization, terrorism and an assortment of other frights, every downtick in GDP threatens to send some interest group or politician off the deep end with cries of foul about Fed policy.
At the same time, suspending rate hikes may give inflationary forces, albeit still nascent, breathing space to take root, strengthen, and haunt the economy down the road. Perhaps that’s why the Fed chief has found reason to promote an on-again/off-again outlook with respect to the price of money.
Sensible perhaps, but espousing a gray area in monetary policy comes with risks in the spring of 2006. Indeed, forex traders smell blood. Even the slightest hint that the Fed is toying with the idea of suspending rate hikes has spurred dollar bashing. In the wake of Bernanke’s comments last Thursday, the U.S. Dollar Index has suffered its biggest decline in more than a month. If the trend continues, it’ll lead to more inflationary pressures by way of imports, which theoretically must rise in price to offset a cheaper dollar. That’s no idle threat for the U.S., which posts a large and growing amount of red ink on its trade ledger.
If the bond market begins to smell inflation-importing risk in any material way, there will be hell to pay in the fixed-income market. Traders have already sold off the 10-year Treasury sufficiently to elevate the benchmark bond’s yield above 5% for the first time in four years. A continued push higher in yield will surely trigger a reassessment of risk across the investment landscape. With most asset classes sitting on hefty gains of late, reassessment in any material way could be painful.
The much-anticipated bond correction may be set to arrive in earnest in 2006, triggering the same elsewhere. In fact, isn’t that what the Fed has wanted all along since it began raising short rates in June 2004? Yes, although the plan was to ease long yields onto higher ground. But the fixed-income set resisted. Is the resistance now giving way to what some might term a higher level of financial sobriety? Meanwhile, if an inspired repricing of bonds is now upon us, will that bring a different result if it unfolds faster rather than slower?
© 2006 by James Picerno. All rights reserved.