Friday, June 6, 2008

Investors probably misread both Bernanke and the ECB

Recent comments by the heads of the Federal Reserve and European Central Bank moved the markets. Federal Reserve Chairman Benjamin Bernanke spoke plainly and clearly and yet was nearly universally misunderstood, but the market tended to like what it thought he was saying. In contrast, ECB President Jean-Claude Trichet was perfectly understood, and investors did not particularly like what he said.

Bernanke spoke at a monetary conference in Spain. He said he wanted to discuss three things: place recent developments in the context of long-term factors, trace how those factors affect the market and the economy, and finally discuss the Fed's response.

The copy of the text of his remarks ran about 22 paragraphs, and the dollar per se was mentioned just three times, all within the last section, and all within one paragraph. Bernanke discussed how the Fed responded and is responding to the forces that are weakening the economy and elevating price pressures.
Plain and Simple

The first mention of the dollar was to state the obvious: Working with the U.S. Treasury, the Federal Reserve continues to carefully monitor developments in the foreign-exchange market. This is not a new initiative or a change in stance. The Federal Reserve closely follows market developments. By citing the Treasury, Bernanke was also paying homage to the division of labor over U.S. dollar policy: It is set by the Treasury Department, not the central bank.

The second mention of the dollar was an identification of the factors that have weighed on the dollar. Here Bernanke did not cite the current account deficit, a conventional explanatory variable. Nor did he cite the diversification of central bank reserves or sovereign wealth funds that others have cited. Instead, he noted that the challenges the U.S. economy faces have generated some downside pressure on the dollar. In turn, the he acknowledged that the decline in the dollar "contributed to the unwelcome rise" in import and consumer prices. In this context, Bernanke said the Fed was attentive to the implications of this for inflation and inflation expectations.

This seems largely consistent with the shifting risk-assessment at the Federal Reserve, which had already signaled somewhat greater concern about the upside risks to inflation than about the downside risks to growth. Essentially, policy makers would like currency values to move in a direction consistent with policy (that is the fundamental that officials seem to refer to when they say currency markets should reflect fundamentals). When growth concerns dominate, a weaker currency is not objectionable. When inflation concerns move into ascendancy, a stronger currency is more desirable.

The third and final mention of the dollar was a reiteration of the Federal Reserve's mantra: Over time, the commitment to the dual mandate of "price stability and maximum sustainable employment," the flexibility of markets, and innovative and productive prowess will ensure that "the dollar remains strong and stable" (our emphasis).

In the Q&A session, Bernanke's audience pressed him a bit more on the dollar. Here, too, he was clear. First, a good part of the dollar recent decline was the unwinding of previous gains. This seems to play down the significance of that decline. Second, he opined that the impact of the dollar on commodity prices has been "relatively modest." This also appears to diminish the importance of the dollar's decline, and it counters those who suggest the Fed's supposed elevated concern was because the weak dollar was driving commodity prices higher.
No Bombshells

Again, there was nothing that shows a shift in policy or some kind of commitment to intervene or in other ways support the dollar directly. While some claim that his comments were pointed and a break from Fed custom, I would conclude the opposite. He did not really speak about the dollar. The dollar was included briefly in his largely academic discussion of the economy. If he did not mention the dollar, it would have been a glaring absence. It is only prudent to consider the currency's impact on inflation in general and imported inflation in particular.

Arguably a more compelling explanation for the dramatic rise in the dollar was that the short-term momentum players, who the media all too often seem to think are the only market participants, were reading the news in a way that justified their positions. However, two days later, the ECB laid any such hopes to rest.
Meanwhile, the Euro

After leaving rates on hold, ECB President Trichet explained that it was in a heightened state of alertness about inflation and that a rate hike next month was possible. It was possible, not a certainty, because the ECB does not pre-commit to rate adjustments. In the Q&A, when asked why the ECB did not hike rates, Trichet replied that it had to prepare the market by first going to a heightened state of alertness. Apparently, to be forewarned is to be forearmed.

Shortly after Trichet's remarks, Bundesbank president and ECB board member Axel Weber, one of the more vocal hawks, warned that the ECB would follow up its words with action.

Taken together, Trichet and Weber have all but indicated that the ECB will most likely raise rates next month. This now has to be the base case view. What can change this in the coming weeks is not weakness in real sector data. Trichet's remarks assume the strong first-quarter growth will not be sustained. Inflation data, broadly understood, is likely to receive the attention of both policy makers and investors.

Sometimes market participants confuse what they personally may believe policy makers should do with what they are likely to do. To be sure, a rate hike would seem to be unnecessarily aggressive and will aggravate the challenges that lie ahead. With price pressures largely emanating from food and energy, in order to get headline inflation down to acceptable levels, the ECB appears willing to drive the sectors into deflation/recession.

Even if the systemic risk to the global financial system has been reduced, banks and insurance companies' balance sheets have deteriorated, and many of these companies are trying to raise cash. The rate hikes, or even the dramatic backing up in European rates, will make this effort more difficult and likely prolong the process of convalescence.

In conclusion, Trichet has trumped Bernanke, in part because Bernanke was not announcing a new policy. Trichet clearly was. These developments suggest that although the dollar may have bottomed against half of the G7 and many emerging markets, the bottom being carved out against the euro will likely be more protracted than previously anticipated. It changes the trajectory, but not, in my view, the underlying direction. In respect to these changes, though, I have lifted a year-end forecast for the euro from $1.44 to $1.47.

No comments: