NEW YORK, May 14 - The dollar's precipitous fall in the last 12 months is proving a boon for a Federal Reserve concerned about deflation, but central bankers elsewhere are looking on with trepidation. The greenback's decline eases U.S. monetary conditions, allowing the Fed to hold back on interest rate cuts for a time when they could be more effective. A four-decade low benchmark fed funds rate of 1.25 percent has kept the Fed's proverbial foot down on the gas pedal, flooding markets with easy money, although economic growth has not accelerated. If easy money is on tap in the United States, the opposite prevails in Europe, whose central bank's slavish adherence to taming inflation with high rates, now 2.50 percent, is limiting borrowing and investment, now compounded by the surging euro.
"In many ways being in this pickle is the best thing to happen to Europe in a long time. Europe has been able to hide behind a cheap currency and stay competitive without having to introduce real structural reform. Now they are going to have live with an overvalued exchange rate," said Michael Rosenberg, chief currency strategist at Deutsche Bank in New York. The ECB's next rate decision on June 5 may be pivotal not only for Europe's sluggish economy, but also for the world's. Between the Fed's recent warning on deflation risks; U.S. Treasury Secretary John Snow's observation a weak dollar helps exports; and mounting discontent among European companies over the euro's strength, ECB officials are playing defense.
Last week's ECB decision to leave rates unchanged despite a weak economy and a strong euro puts the onus on Europe to cut. ECB officials hedged their bets this week, telling finance ministers from the euro zone the bank now had room to cut rates if oil prices stayed low -- and contributed to low inflation -- and the euro's lofty value was sustained. A falling dollar exports deflationary pressures toward the euro zone. Combined with a sluggish European economy, the ECB is in an even bigger pickle because European exports are pinched and firms can't raise prices to boost profit margins.
But even if the ECB cuts rates, analysts do not expect the narrower interest rate advantage that euro-based assets have over dollar-based ones to make the euro reverse course. "European equities would have a tougher time going forward because the strong euro makes it tougher to sell abroad and profits will fall. However, softer growth and low inflation will have a tendency to support bond prices," said David Durrant, chief currency strategist at Bank Julius Baer in New York. If 2003 is a repeat of 2002, then the trend in investment flows favoring European bonds over European equities will keep the euro's value high.
NO COMPLAINTS
"The dollar can do a bit of the heavy lifting for the Fed," said Durrant. Wall Street is split on what the Fed will do at its next meeting June 24-25, with a slight majority favoring no change. In the last week Snow has repeated ad nauseam the "strong dollar" mantra but added a twist by highlighting the export-boosting benefits of a weak dollar. He said there is no policy to manipulate the currency and belittled intervention. Investors interpret his rhetoric as a tacit retreat from the "strong dollar" policy and contributing to a dollar sell-off. The euro , already soaring, surged to a 4-1/2-year high of $1.1623 on Monday before investors booked some profits, dropping the euro to $1.1498 on Wednesday. "Snow's comments suggest something a little more directive, or active, than benign neglect," said Anne Parker Mills, senior U.S. economist with Brown Brothers Harriman, New York.
Macro-political advisory group Medley Global Advisors said in a report viewed by market sources that U.S. Treasury Department officials are not too upset with the dollar's fall. The report said officials would counter critics of the weakening dollar by telling Europe to cut rates and Japan to undertake structural reforms.//