Over in London, Fleet Street Daily’s Ben Traynor says the dollar’s recent rally won’t last long.

Foreign governments are increasingly twitchy about holding dollar reserves or maintaining dollar pegs. But more importantly, the Fed has shown that it is more concerned about economic growth and safeguarding the financial sector than it is about inflation.

Ben says that by neglecting the threat of rising prices, the Fed is sending the buck down a slippery slope…

From Reuters last week:

The U.S. dollar’s recent rally has provoked a significant reversal in sentiment in the greenback’s favour among options investors, most of whom are convinced the currency’s seven-year downtrend is over.

I disagree. I believe this rally will be a short-lived thing.

There are several reasons I could give for why I think the dollar will fall in the long run. There’s the fact that foreign governments — like China’s — are sitting on huge piles of dollar reserves. They need them to buy commodities like oil, which is traded in dollars. But I suspect that, given half a chance, they’d ditch some of those reserves and diversify into other currencies.

Then there are those Gulf nations whose currencies are pegged to the greenback. In recent years this has led to them importing inflation. Inflation is the last thing these fast-growing economies need, hence their desire to break the dollar peg. This, of course, would cause also cause a dollar sell-off.

But the number on reason I dislike the dollar is the Federal Reserve. The Fed is ultimately responsible for maintaining the dollar’s value. That’s the Fed’s job. At least, it’s some of it — the part called ‘price stability’.

But the Fed has a dual mandate. It is also asked to strive for full employment. Now, of course, a schoolboy studying GCSE economics could tell you that — barring an uncannily benign set of circumstances — these two goals are mutually incompatible. But there you have it. This is what the Fed is asked to do — keep prices down, keep jobs up.

The Fed has shown it will sacrifice the dollar to save the economy

There is a separate, but closely-related, tension between price stability and financial stability. Ever since the credit crunch began, maintaining financial stability has been priority number one.

Ben Bernanke, the Fed chairman, is widely known to be suspicious of the laissez-faire approach. As an expert on the Great Depression, he admires Franklin Roosevelt’s proactive approach. Bernanke is a man who errs on the side of central bank aggression.

Let’s recap on what the Fed has done over the last year or so:

• Slashed interest rates to 2%.
• Set up the “term auction facility” to allow banks to borrow anonymously and more cheaply from the Fed’s discount window.
• Agreed to swap up to $200 billion of Treasuries for illiquid mortgage-backed securities.
• Absorbed $29 billion of Bear Stearns’s debt — this was to help JP Morgan buy Bear Stearns.
• Allowed investment banks to borrow from the discount window for the first time since the Great Depression (usually only banks that take retail deposits are eligible).
• Agreed to let Fannie Mae and Freddie Mac use the discount window if necessary

It has been argued, rightly, that the above measures — in particular those relating to Bear Stearns and Fannie and Freddie — have made it much harder for the Fed to knock back similar requests in future.

But the Fed is getting itself into a hole. Only 52% of its assets are in government bonds. A year ago the figure was 91%. The Fed has spilled toxic waste all over its balance sheet. It has justified this to itself with the notion that it was all done in the greater good.

Maybe that’s true. Maybe Bernanke’s doing the right thing; maybe he isn’t. That’s the subject of a whole other discussion.

For our purposes, what matters is what will happen to the dollar. And pumping liquidity into the system is not exactly designed to keep the greenback strong. I expect it will respond to future crises in a similar manner.

The Fed’s actions are a clear demonstration that it puts economic and financial considerations ahead of maintaining the dollar’s value. It is being distracted from the fight against inflation.

A non-independent central bank

Paul Volcker has gone down in legend as the Fed chairman who, in the early 1980s, snuffed out the stagflation of the preceding decade. He has commented on the Fed’s expanding role:

“[The Fed is] getting into areas that are not typically thought to require the degree of independence that monetary policy does.”

The Fed seems to be becoming more politicised. Perhaps it had to; maybe it’s not its own fault. What we do know, though, is that this makes it harder for the Fed to fulfil the price stability part of its mandate.

As the Fed leans towards safeguarding the economy and the banking system, it leans away from keeping inflation in check. That may be good news for the US economy (at least in the short term). But it is bad news for any non-US investor who is holding the dollar.

Source: The Number One Reason Why I Don’t Like The Dollar