An editorial in Monday’s Wall Street Journal noted that the dollar “has surprised the markets with its relative strength.” Relative strength is the operative term where the dollar is concerned, as its 13 percent rise versus the euro and yen masks its underlying weakness. As WesternAsset chief economist Scott Grannis said in a client report last week, “the best that can be said about the dollar is that it is among the strongest in a weak field.”
Evidence supporting Grannis’s contention abounds. While the price of gold has risen 23 and 27 percent respectively in euros and yen in the past year, the dollar price of gold has risen too — albeit by 9 percent. Oil? The price of a barrel has risen 17 percent in dollar terms since last November alongside 33 and 36 percent increases in euros and yen. Belying the theory that expensive oil is the unique result of gouging by OPEC and/or Big Oil, copper per pound is up 33 percent in dollars against 51 and 55 percent elevations in euros and yen.
One area of debate among currency-watchers has to do with the effectiveness of using the “bank rate,” or the fed funds rate, to shore up the value of currencies. Presumably everyone would agree that doing so is not completely effective, as evidenced by the long-term underperformance of the Brazilian real and Turkish lira despite nominally high interest-rate levels in both countries. Conversely, the yen rose against the dollar throughout much of the 1990s despite the Bank of Japan’s targeting of a bank rate far lower than that maintained by the U.S. Federal Reserve.
Since the Fed began raising rates in June 2004, the dollar price of gold has risen nearly 25 percent. While the “unseen” in this case might be what the price of gold would be today absent the 300 basis points in hikes, it also could be said that Fed tightening hasn’t worked as advertised.
Importantly, there are historical examples that point to the ineffectiveness of rate hikes in reining in dollar liquidity. Despite a 900 basis point rise in the fed funds rate from 1976 to 1980, the dollar price of gold rose over 500 percent in that time, from $140 an ounce to $850.
Looking overseas, in 1972 the Bank of England began a series of rate hikes that similarly occurred alongside a fall in the value of the pound. The assumption then was that the rise in England’s bank rate created a “get-it-while-you-can” rush for money, and it seems reasonable to assume that this same mentality is at play here. Furthermore, if the markets see the rate mechanism as an ineffective way to reduce excess dollar liquidity, do incentives exist for the marginal investor to exit U.S. assets (creating more dollar liquidity in the process) if rate hikes are believed to induce inflationary pressures?
All this isn’t to say that the Fed should end the process by which it seeks to strengthen the dollar. But it might argue for a different strategy. Steve Forbes has advocated the Fed’s floating of the interest rate that it presently sets while using open market operations to reduce dollar liquidity. The fed funds rate would presumably jump in the near term if this were the case, but with the removal of excess dollar liquidity from the system, the long-term result would arguably be lower rates along the yield curve.
Whatever happens, it seems reasonable to question the present Fed strategy amidst a falling dollar. While floating the fed funds rate may not be the cure-all some suggest, it’s fair to reassess Fed policy with gold trading in the $500-an-ounce range.
–John Tamny is a writer in Washington, D.C. He can be contacted at jtamny@yahoo.com.