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Fed's policy shift shakes the dollar, but shouldn't crush it

March 20, 2009 |  6:00 am

The Federal Reserve wants long-term interest rates to drop. But along the way, the central bank has to think about how much it's willing to allow the dollar to drop, as well.

Traders have hammered the buck over the last two days, after the Fed on Wednesday surprised markets by committing more than $1 trillion toward purchases of mortgage-backed bonds and Treasury bonds.

The currency market’s knee-jerk reaction was that the Fed will be flooding the world with more greenbacks, inevitably sparking inflation and devaluing the dollar. So, sell it.

The dollar quickly tumbled against most major and minor currencies, as speculators had their way with it. Still, as the accompanying chart shows, the buck hasn’t collapsed.

Dxyindexmarch19_2 As tracked by the DXY index, which measures the dollar’s value against a basket of six other major currencies (including the euro and the yen), the U.S. currency fell 4.4% from Tuesday through Thursday, but remains well above its recent lows reached last spring.

On one hand, China and other foreign owners of U.S. Treasury bonds have a vested interest in the Fed's new gameplan: If it succeeds in pushing bond yields lower, the result will be to boost the value of outstanding Treasuries issued at higher fixed rates. That ought to make foreign investors want to stay put in dollar-denominated bonds.

But if the greenback continues to slump, what foreigners gain in bond appreciation could be lost to currency depreciation.

When the dollar was sliding for most of 2002 through early-2008, it was largely viewed as a good thing for the U.S. economy by making American exports cheaper abroad. Because most commodities are priced in dollars, the buck’s downturn also made raw materials relatively cheaper for foreign buyers, stoking the global economic boom.

The rebound in the dollar since mid-2008 reflects the flight-to-safety amid the worldwide financial crash. But there’s a strong argument on Wall Street that the dollar should go lower, in the long run, to continue rebuilding the export sector of the U.S. economy.

The issue for the Fed, and the U.S. Treasury, is the pace of the dollar’s losses. A gradual decline would be fine. A high-speed plunge could induce terror, including among foreign owners of Treasury debt.

But the Fed may have good reason not to worry about a dollar collapse in the near term: Although speculators may have a little fun attacking the buck, it would be downright absurd for global investors to engage in wholesale dumping of dollars in favor of euros, pounds, yen or most other currencies.

Strong currencies are supposed to belong to strong economies. Does that describe Europe, Britain or Japan at the moment?

-- Tom Petruno