April 28, 2011 3:52 PM EDT
In Wednesday’s post-FOMC press conference, Federal Reserve Chairman Ben Bernanke betrayed an utter lack of understanding in the US dollar and foreign exchange market.
He claimed he wants “a strong and stable dollar.” He said plans to achieve that through maintaining low inflation and supporting a strong economy (which he hopes will attract portfolio inflows to the US).
This plan sounds reasonable on paper and may fool people who aren’t familiar with the forex market. In reality, however, it betrays an utter ignorance of the US dollar and forex market (assuming Bernanke is sincere in telling us that he wants a strong dollar).
First of all, interest rate differentials are the primary driver of foreign exchange rates for freely-floated currencies for the majority of time.
The key reason is that the carry trade dominates the forex market. Another reason is that higher interest rates attract portfolio inflows to fixed-income securities.
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Second, the dollar is a funding currency for the carry trade, so it’s inversely correlated with global risk sentiment. If Bernanke’s QE2 actually kicks US economic growth into high gear, whatever portfolio inflow support to the dollar will be nullified by the surge in the carry trade.
Moreover, there is a secular trend of portfolio managers allocating more money to emerging market equities. Does Bernanke really want to hinge his strong-dollar thesis on the US stock market competing with those of booming emerging market economies?
A third major factor that drives US dollar strength is its status as a reserve currency. Indeed, the dollar weakness in the past few weeks has been driven in large part by foreign central banks dumping dollar-denominated assets from their foreign exchange reserves.
This dollar-dumping trend is almost entirely Bernanke’s fault because he critically damaged foreigner central bankers’ faith in the US dollar.
In the last few years, Bernanke printed massive amounts of money through money-printing sponsored bailout programs, QE1, and now QE2.
Money printing is considered an act of bad faith by creditors because you’re essentially diluting the value of their claim.
Even back during QE1, the Chinese – who are the largest foreign holders of US Treasuries – were highly concerned about money printing.
In May 2009, Dallas Fed chief Richard Fisher, after a trip to China, said “senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature… I must have been asked about that a hundred times in China,” reported the WSJ.
QE2, then, was simply the last straw for China and other creditors.
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