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[Bullwinkle]

Bernanke Puts the Dollar on Fed's Radar
by Action Economics staff
June 3, 2008, 1:03PM EST


The Federal Reserve chief says the central bank is paying attention to changes in the value of the U.S. dollar and their contribution to in

Federal Reserve officials almost never speak directly on the U.S. dollar, a matter usually left to the Treasury Dept. But the Fed hasn't stuck to its traditional playbook in the past few months, with a speech via satellite to the International Monetary Conference in Barcelona, Spain, on June 3 by Fed Chairman Ben Bernanke providing yet another example. Bernanke spent an entire paragraph on the dollar, as policymakers have finally come to the conclusion that the falling dollar will keep inflation risks high.

Thus Bernanke noted: "In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets. The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation."

Bernanke said the central bank was paying attention to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of its dual mandate—maintaining price stability and fostering conditions for economic growth—including the risk of an erosion in longer-term inflation expectations.

"Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy—including flexible markets and robust innovation and productivity—will be key factors ensuring that the dollar remains a strong and stable currency."

The Fed chief's comments sparked a rally in the dollar, with the greenback gaining in value vs. other major currencies. His remarks could indicate a significant shift in thinking on the Fed's part, where the dollar could play a larger role in policymaking decisions.

Policy Stability

Bernanke also said Fed policy is well positioned for growth and price stability, reinforcing market expectations that the central bank is on hold for now with regard to interest rates. He noted that the markets have improved but remain "strained." The second quarter should be "relatively weak," though better conditions are expected over the second half of the year. However, inflation has remained high due to sharp increases in globally traded commodities, though pass-through has been limited.

But he added that the possibility that commodity prices will continue to rise is an important risk to the Fed's inflation outlook, as is the potential that the public will build in rising inflation expectations. The Fed will guard against the jump in price expectations, he warned. The comments are fairly consistent with the tone of the April Federal Open Market Committee (FOMC) minutes.

Reading between the lines, from his perspective it sounds like policy stability is the most likely outcome rather than further cuts or a quick hike on the horizon.

Bernanke's remarks on inflation risks related to the weak dollar gave the bond market pause and sent bond yields marginally higher after they had already backed up after a rebound in stock prices on June 3.

Fed funds futures, a vehicle for market pros to make bets on the future direction of interest rates, sank modestly into the red after Bernanke largely confirmed market expectations that the Fed is on hold for now. And with Bernanke's belief that economic conditions will improve over the second half of the year, the market continues to price in better risk for a rate hike as the next move, although it's not likely until near yearend. The futures market is pricing in about 75% to 80% risk for a quarter-point tightening later in the year, which would take the federal funds rate to 2.25%.

http://www.businessweek.com/investor/content/jun2008/pi2008063_666084.htm?chan=search