Unless Chairman Bernanke’s recent statement about the US dollar signals either a greater willingness to raise rates (or not to lower them) than before, or a greater readiness to conduct foreign exchange market intervention to stop the US dollar from falling further, it was cheap talk.

I can see two plausible sets of circumstances that would permit a test of the cheap talk hypothesis. The first would be a sharp weakening of the external value of the US dollar (as measured by its effective or trade-weighted nominal exchange rate) not associated with an obvious further weakening of domestic activity. An increase in oil prices caused by a negative shock to oil supply would be a possible trigger for such a configuration of economic outcomes.

In that case, were the Fed to believe that foreign exchange market intervention is an effective tool for influencing the external value of the US dollar, a coordinated intervention in the foreign exchange market (with at least the ECB, but preferably also the Bank of England and the Bank of Japan participating) would confirm the seriousness of the Fed’s commitment to price stability.

The ECB would be likely to participate if the bilateral exchange rate with the dollar were to rise above $1.60 per euro or so. I would not expect any lasting effect from sterilized interventions of this kind, unless they are, for reasons unknown, interpreted as conveying news about future movements in the monetary policy instruments that do matter, that is, in official policy rates. I suspect that Chairman Bernanke’s views on the effectiveness of foreign exchange market intervention are not a hundred miles from mine, so we may never observe this possible refutation of the cheap talk hypothesis.

The second set of circumstances would be where a substantial weakening of the external value of the dollar is accompanied by a marked weakening of US economic activity. Given the disproportionate weight given since 1987 by the Fed to the sustainable high employment leg of its mandate (at the expense of the price stability leg of the mandate), we could have expected a prompt further cut in the Federal Funds target rate. The size of the rate cuts would be constrained only by the unfortunate technical nuisance of a zero floor under nominal interest rates. If the Fed were sufficiently innovative, even that need not be an obstacle; by taxing currency a negative nominal interest rate would be achievable.

I interpret Bernanke’s statement as hinting that the readiness to cut the Federal Funds target rate from its present level in response to a further unexpected substantial weakening of economic activity would be materially diminished if either the weaker activity level were accompanied by a weakening US dollar or if it were feared that such a rate cut itself would lead to further US dollar weakening.

The other interesting (and to me gratifying) element in his speech was the continuing rehabilitation of headline inflation. The Fed may still believe that core inflation is a better indicator of underlying inflationary pressures and of headline inflation in the medium term than current headline inflation (as an aside, the appropriate response to such a statement would be: ‘yes, possibly, and what if it were?’). The Fed does, however, recognize that persistent high headline inflation of the kind we have seen for the past four years or so are likely to cause short-term and medium-term inflation expectations to drift up. Once the medium-term inflation anchor is cast loose, only greater excess capacity and higher unemployment can bring inflation down.

The Fed appears to be waking up belatedly to the danger of the inflation monster it has incubated. But better late than never. Let’s look at actual interventions and rate decisions to determine what price tag to attach to the Chairman’s talk.

June 5th, 2008 in Economics, European Union, Financial Markets, International Trade, Monetary Policy, Politics | Permalink