ECONOMETER

Did Fed Chairman Bernanke really provide any real support to the dollar when he said at the Board of Governors conference on Thursday that the Fed will be prepared to tighten monetary policy when the outlook for the economy “has improved sufficiently”. Various newswires report that these comments have given the dollar some relief but the reality is that Bernanke only stated the obvious. Of course the Fed has to raise interest rates at some point and most likely this will be when the economic recovery looks sustainable. There is indication when this point in time will be, however.

In fact there was unsurprisingly no sign from Bernanke that the Fed was preparing to raise rates any time soon. As was noted in the September 23 Fed FOMC statement Bernanke reiterated that the Fed “believe that accommodative policies will likely be warranted for an extended period”. An extended period could mean at the least some months but even years and this is no exaggeration.

In 2001 the Fed did not begin to hike rates until around 2 ½ years after the end of the recession whilst in 1990-91 rates did not go up until close to 3 years after recession ended. Arguably this recession was worse in terms of depth and breadth suggesting that it will take a long time before the Fed even contemplates reversing policy. In any case the first step is to reduce the size of the Fed’s balance sheet.

Admittedly there has been some suggestions from other Fed members that when interest rates are raised it may be done “with greater force” as stated by Fed Governor Warsh recently but others such as NY Fed President Dudley have said that the pace of recovery “is not likely to be robust”, suggesting a more cautious tone and also highlighting that there is some debate within the Fed about the timing of exit strategies and raising interest rates.

There is no doubt that some Fed members are becoming more nervous about holding policy at such an accommodative level but it could still be several months before policy is reversed given the massive excess capacity in the product and labour markets and benign outlook for inflation. Judging by past history markets have little to be nervous about in terms of an early rate hike.

For the dollar this is bad news and as noted in my previous post the dollar will suffer from a growing yield disadvantage as other countries raise interest rates ahead of the Fed. The dollar may have benefited from some short covering at the end of the week and this could have been provoked by Bernanke’s comments but if so, the dollar’s gains are likely to be short-lived as investors take the opportunity of better levels to take short positions in the currency.