US dollar plunges, tips deflation fears Europe's way

WASHINGTON (AFP) - Nerves gripped investors worldwide after US Treasury Secretary John Snow appeared tacitly to abandon an eight-year policy of supporting a strong dollar.

The perceived shift raised fears that further dollar declines would erode the value of foreigners' US investments, economists said.

And while soothing concerns of deflation in the United States, it also ramped up those same fears in Europe, and complicated the long deflation battle in Japan, they said.

"What the United States has made clear is that they are not going to undertake any efforts to try to defend the currency," said Citigroup global currency strategist Robert Sinche.

"In a world where the major concerns appear to be about deflation rather than inflation, the last thing the world economy needs is to have the United States trying to artificially tighten policy."

US Treasury Secretary John Snow described recent currency fluctuations as being "really fairly modest" during a weekend Group of Seven finance ministers in Deauville, France.

A "strong dollar" policy did not mean that the currency should be at any particular exchange rate, he said, emphasising that it incorporated other values such as confidence, or being a good medium of exchange.

The euro rose to 1.1720 dollars in late morning deals in Europe, against 1.1581 on Friday in New York.

In Japan, already battling deflation for four years, the authorities in Tokyo intervened heavily to prevent a yen appreciation. The dollar tumbled to 115.13 yen from 115.90 on Friday.

"I think for the longest period of time in effect the dollar exchange rate has been market-determined," said Moody's Investors Service chief US economist John Lonski.

Chronic deficits in US financial dealings with the outside world -- shown by a current account shortfall of more than half a billion dollars last year -- might have caught up with the currency, Lonski said.

"We are simply not able to attract as much foreign capital as we need to prevent the dollar exchange rate from moving lower. I wonder how much of this is really the product of any change in policy," he said.

Major investors in dollar-denominated assets also might have decided to diversify because of heightened geopolitical concerns, Lonski said.

In addition, the US Federal Reserve (news - web sites) had cut the key federal funds target rate to a four-decade low of 1.25 percent. Lower rates reduce the returns on US investments, eroding demand for dollars.

For now, the slide in the dollar worked in favor of the US economy, where underlying inflation fell to a 37-year low of 1.5 percent in April when compared with April 2002.

The appreciation of the euro, and the higher risk of deflation, might force the European Central Bank to cut rates sooner, the analyst said.

"The attack against deflation becomes globalized if the ECB decides that it has no choice but to cut rates pretty soon." The ECB holds its next meeting June 5.

In Japan, the Bank of Japan had waged a long battle in vain against deflation. "The last thing they need is a further appreciation of their currency," Lonski said.

Snow would still step in to support the dollar if the decline ran out of control, leading to a flight of funds from both the equity market and the bond market, he predicted.

"Snow made it perfectly clear, the strong dollar policy has been abandoned up until we reach that point where expecations of further dollar weakness prove to be disruptive to US financial markets," Lonski said.

Wall Street tumbled Monday. The Dow Jones industrials average of 30 top stocks plunged 171.33 points or 1.97 percent to 8,507.64 by early afternoon. But the bond market held up relatively well, Lonski said.

"If both equity and credit markets deteriorate together, chances are the dollar depreication will no longer be tolerated by the US government," the economist said.

Here's an article some of you may be interested in seeing, in case you missed it:

US dollar's slide is a calculated move
Straits Times (Asian Newspaper) By Eddie Lee
http://www.straitstimes.com/commentary/story/0,4386,188582,00.html?

IT NEVER rains but it pours in the forex market.

And if you were caught long on the United States dollar, there wasn't enough time to run for shelter. In just the past week, the US dollar fell 1 to 2 per cent against the euro, Japanese yen and Singapore dollar. The sudden change in mood is generally attributed to two men and a twin deficit.

The twin deficit is old hat.

America is now running the largest current account deficit in its history, totalling US$503 billion (S$876.2 billion) last year, or almost 5 per cent of the country's GDP. That is, US purchases of goods and services from the rest of the world exceeded its sales to the same group by US$503 billion.

A country in debt must eventually repay by devaluing its currency.

A contributory factor behind the current account deficit is the country's budget deficit. US President George W. Bush's proposal to cut taxes on dividends over the next decade will add up to an estimated bill of US$550 billion for the US government (the exact amount is still being debated in Congress). By boosting spending, US imports will increase and add to the current account deficit.

Forex traders also point to Federal Reserve Board chairman Alan Greenspan's warning of a further fall in the inflation rate as a cause for the fall in the greenback. It raised the likelihood of another round of interest rate cuts.

Treasury Secretary John Snow didn't help matters when he appeared nonchalant about the dollar's decline. He said he was 'not particularly concerned'.

But the really intriguing question is whether the Fed has started to use unconventional weapons in preventing deflation. Morgan Stanley's Dick Berner is one economist who believes so. He suggests: 'The Fed is already quietly using another key weapon in its deflation-fighting arsenal, namely a weaker dollar... It has brought US interest rates lower than most on the planet, and in a world of single-digit returns, yield-hungry investors are looking elsewhere.'

And what the US wants, it gets.

The Fed has long indicated its awareness of the potential problems of deflation. In a widely publicised research report by Federal Reserve economists in June last year, 'Preventing Deflation: Lessons from Japan's Experience in the 1990s', they argued the lesson to be learnt from Japan was that the best way to fight deflation was to avoid it.

The danger is in being too complacent. Deflation in Japan was almost entirely unanticipated by both foreign and Japanese observers.

Federal Reserve governor Ben Bernanke's speech to the National Economists Club in Washington on Nov 21 last year laid out the broad strategy. He argues that as 'deflation is in almost all cases a side effect of a collapse of demand, the Fed should try to preserve a buffer zone for the inflation rate - that is, during normal times, it should not try to push inflation down all the way to zero'.'

The idea of maintaining an inflation buffer zone is to reduce the risk that a large and unexpected drop in demand does not tilt the economy into deflationary territory and drive interest rates to zero. So central banks should not allow the inflation rate to fall below some agreed minimum rate.

In fact, Mr Bernanke only recently renewed his call for an inflation target.

In an interview with the German newspaper Frankfurter Allgemeine Zeitung on April 10, he said: 'The Fed has had considerable success in fighting inflation. Now our task is to anchor the public's and the financial markets' inflation expectations.'

A possible range he suggested for 'acceptable' inflation could be for a rise in an agreed consumer price index of between 1.5 and 2.5 per cent.

It is a testament to the resiliency and flexibility of the US economy that output continues to increase, despite disruptions by a number of unexpected events during the past two years - namely, the Sept 11, 2001 terrorist attacks in the US and the Iraq war.

But the price paid is a fall in the inflation rate (excluding energy and food prices) to just 1.7 per cent.

Amber lights are likely to be flashing within the Fed.

Three methods to fight deflation have been outlined by its governors in various speeches during the past year: monetary easing, purchasing securities by the Fed, and purchasing of non-dollar denominated assets to devalue the currency.

All of these are being proposed with the objective of creating inflation or, to be more precise, of creating the expectations of inflation.

Monetary easing is the conventional weapon. But there are limits to this, given that the key short-term interest rate - the Fed funds rate - has already been reduced to 1.25 per cent, a 40-year low.

The alternative is for the Fed to purchase Treasury bonds in order to lower long-term interest rates. Mortgage rates and corporate bonds are tied to Treasuries, so bringing Treasury yields down will lower borrowing costs.

The Fed may have already made its first move by announcing its concern over a further decline in the inflation rate. Treasury bonds have rallied sharply since the Federal Reserve meeting, pushing the yield on the 10-year note down to 3.65 per cent, from 3.89 per cent.

There's an even subtler move. The disinflation warning effectively separated concerns of inflation from growth.

While traditionally, financial markets worry about inflation when there's growth; now, you can have growth without inflation.

Mr Greenspan is conditioning the markets to expect a low interest rate environment even when growth picks up. He wants to be sure inflation clears the buffer zone before interest rates start rising.

Mr Bernanke believes a weaker dollar policy can also work.

He cites the example of then-president Franklin Roosevelt devaluing the dollar against gold in 1933-34, enforced by a programme of domestic money creation.

The devaluation and the rapid increase in money supply reversed the deflationary trend. Consumer price inflation in the US rose from minus 10.3 per cent in 1932 to 3.4 per cent in 1934. He points out 'the economy grew strongly and, by the way, 1934 was one of the best years of the century for the stock market'.

The US dollar's descent smells of a premeditated move rather than just the shifting moods of forex traders.

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