We are now importing inflation. This does
not only apply to the cost of commodities, such as
oil, but also to consumer goods imported from
Asia. This is a newer trend as, in our analysis.
Asia had been exporting deflation until the summer
of 2006; since then, we have seen increased
pricing power by Asian exporters.
Inflation is not just a US phenomenon; as
Asian economies are far more dependent on
agricultural and industrial commodities, rising
inflation may become a serious concern in the
region. The stronger and more prudent Asian
central banks may realize that allowing their
currencies to float higher versus the US dollar
may be the most effective way to combat
inflationary pressures.
Available credit
is likely to continue to be tight. In a move that
former Federal Reserve
chairman Paul Volcker referred to as being at "the
very edge" of the Fed's legal authority, the Fed
in March engineered a bailout plan to avoid
bankruptcy for Bear Stearns, up until recently a
major investment bank. This was followed by moves
to allow investment banks not regulated by the Fed
to swap "investment grade securities" for Treasury
securities. Basically, this allows financial
institutions to turn illiquid reserves into liquid
ones to survive.
However, because the
Treasury securities are merely loans against the
collateral provided, banks continue to own a lot
of securities that - in our assessment - should
rather not be used as reserve capital. As a
result, banks may be reluctant to extend credit
out of fear that their balance sheets continue to
be weak. Similarly, banks may continue to be
reluctant to extend overnight loans to one
another.
In our assessment, these
emergency measures by the Fed prolong the credit
contraction. To get through the credit crisis, we
believe regulators should apply far more pressure
on financial institutions to find substantially
new capital, replacing questionable reserves with
good ones. While a lot of progress has been made,
the terms of any capital infusions that we have
seen suggest to us that a lot more work is ahead
for the banks.
This is relevant to the US
dollar because the lack of available credit is a
negative for economic growth; because of the US
current account deficit, the US dollar is
particularly vulnerable to an economic slowdown.
This is in contrast to Europe, where an economic
slowdown may not be a positive for the currency,
but because the current account is reasonably
balanced within, say,
the euro-zone, an economic
slowdown need not directly translate into a weaker
euro.
Add to that the more solid monetary
policy by the European Central Bank. The bank's
president, Jean-Claude Trichet, has said that
during times of turbulence, it is imperative that
inflationary expectations remain firmly anchored.
Just as importantly, his words have been followed
by action, namely by not cutting interest rates as
a result of the global credit crisis.
We
have been a vocal critic of interest rate cuts in
the US because, in our assessment, they do much
more harm than good: subprime borrowers or holders
of illiquid debt instruments are shunned from the
markets in the current environment because of
general risk aversion, not because of the level of
interest rates. Lower interest rates, however, may
cause inflationary pressures to build further and
may cause further downward pressure on the dollar.
In this context, we conclude that it may
well be in the Fed's interest to have a weak
dollar. This is consistent with what we interpret
to be Fed chairman Ben Bernanke's disliking of the
gold standard. In his book Essays on the Great
Depression, Bernanke argues that countries
that abandoned the gold standard recovered from
the Depression more quickly. Similarly, based on
our analysis of his academic publications before
becoming Fed chairman, we believe that Bernanke
may actively work to weaken the US dollar in what
he may consider an effort to alleviate hardship on
the people.
The Fed may be encouraged to
pursue a weaker dollar because, in the past, a
weaker dollar did not necessarily result in higher
inflation. However, this does not mean that
actively pursuing a weaker dollar will not cause
significantly higher inflation. We are seeing
signs that the weaker dollar is taking a heavy
toll on inflation as import prices are up about
15% in the 12 months ending March 31, 2008. While
high oil prices are contributing to inflationary
pressures, prices are higher across goods,
services and geographies.
As inflationary
pressures increase, the Fed may not be able to
tighten monetary policy out of fear that the
fragile financial system may be unable to cope
with a restrictive monetary policy. Indeed, we
believe the Fed seems to encourage inflation to
allow financial institutions to repair their
balance sheets. In our assessment, the Fed would
welcome inflation in the current environment,
despite their public pronouncements to the
contrary, as long as it was uniform, that is if
there was also wage inflation.
Axel Merk is the
portfolio manager of the Merk Hard Currency Fund,
a no-load mutual fund that invests in a basket of
hard currencies from countries with strong
monetary policies assembled to protect against the
depreciation of the US dollar relative to other
currencies.
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