Banking on a dollar rally
The stakes could not be higher in the deadly combat between soaring oil prices and the greenback
Who is calling the tune in currency markets? In recent weeks, events on the foreign exchanges have come to resemble a stupendous game of chicken. Which will snap first: the forces behind the soaring oil price, or the forces attempting to mount a sustained rally in the dollar?
The stakes could hardly be higher. On the outcome of this epic tussle depends not just where the dollar and other major currencies are likely to be a year from now, but whether America and the eurozone are destined for mild recession – or prolonged stagflation.
With the onset of the credit crisis last August, the US Treasury was content to see the dollar fall, improving the prospects for American exporters and helping to cut America’s massive balance of payments deficit. Benign neglect of the dollar, it was thought, would help the manufacturing sector and cushion the downturn arising from the subprime mortgage debacle and the worsening slowdown in the housing market. Remarks in February by Ben Bernanke, chairman of the Federal Reserve, on the benefits of dollar weakness for exports, fuelled this decline.
This policy lasted until early May. It then underwent a dramatic change. The soaring oil price – and rising prices of imported foodstuffs – were stoking a potentially severe problem with inflation. The weak dollar, far from being an asset, was now seen as a liability, and one that magnified every fresh surge in the price of oil. Better, it was thought, that the dollar now staged a sharp rally that would help staunch the rise in the oil price and ease pressures on the Federal Reserve to switch from a stance of cutting interest rates to raising them. Thus, from fighting the continuing problems of the global credit crunch, the battle swung to fighting the spectre of inflation.
The period of benign neglect of the dollar was visibly brought to an end in early May following a meeting of G7 finance ministers and central bank governors. This registered official concern over the impact of ‘at times sharp fluctuations in major currencies’ on economic and financial stability.
Subsequent statements have helped to stabilise the dollar and then to support a stuttering rally against the euro. Jean-Claude Trichet, president of the European Central Bank, described the euro’s strength against the dollar as ‘worrisome’. In America there was also concern over the billowing US petroleum deficit. This had risen from 1 per cent of GDP in 2003, to 3 per cent by early 2008, more than wiping out the improvement in the non-oil deficit. Further remarks by Bernanke hinting that the Fed may need to raise interest rates to curb inflationary pressure – America’s inflation rate has jumped from 1.9 per cent last August to 4.3 per cent – sent the US currency sharply higher.
Since then, the oil price and the dollar have been in deadly combat. Policy preference is one thing, realisation quite another. The US is not the global price-setter that it was. According to the IMF, emerging and developing countries together generated around 70 per cent of world growth in 2007, China alone generating around 25 per cent. Since the start of 2005, China has accounted for almost all the increase in world demand for key metals such as aluminium, copper and zinc. And since 2000, around one third of the increase in world demand for oil has emanated from China. Every fresh upward move in oil has knocked the dollar back while signs of a price easing are seized upon as evidence of the dollar beginning to rally.
What of the militantly anti-inflationary European Central Bank in all of this? If US Treasury secretary Henry Paulson was counting on help from Europe and co-ordinated support through G7 to help a sustained dollar rally, he would have been disappointed. Earlier this year, it looked a reasonable bet that the ECB, faced with mounting evidence of a deepening economic slowdown, would follow the US Fed in bringing interest rates down.
But expectations here, too, have changed sharply, coinciding with the change in the US stance over the dollar. In early June, at the same time as the US was seeking a dollar rally, Trichet declared that the ECB’s Governing Council was in a state of ‘heightened alertness’ over inflation. This was widely interpreted to mean it was poised to raise rates. ‘I don’t say it’s certain. I say it is possible,’ he added by way of clarification. It still pushed the dollar sharply down against the euro.
To add to the sense of disarray, Yves Mersch, a member of the ECB Governing Council, subsequently declared a eurozone rate rise was a ‘possible certainty’. Whatever was that supposed to mean? The phrase ‘possible certainty’ must surely now merit a page of its own in the Bumper Book of ECB obfuscation. More seriously, the failure of recent rounds of G7 and G8 meetings to effect any real policy co-ordination must call into question that global financial architecture on which Gordon Brown has placed so much reliance.
So what does all this suggest about the future direction of the dollar, the euro and sterling? A discomforting truth in all of this is that the oil price is out of the control of central banks and finance ministers. America’s authority has also been visibly weakened as its economy has slowed, with some of its leading investment banks dependent on sovereign wealth fund support. Adding to the uphill task for the dollar is the US Presidential election and uncertainty over changes in policy emphasis that a new administration will bring.
As for the ECB, while it has repeatedly stressed its mandate to deliver price stability, it has to consider the impact on monetary stability of higher interest rates and growing economic divergence within the eurozone. While Germany’s economy performed better than expected in the first quarter, a rate rise would create serious problems in Spain, already reeling from a construction and property slump; in Italy, where the government is pushing for tax increases; and in France, which is now seeing a serious downturn in business activity and consumer spending.
Policymakers in Europe and America have one last escape card from this malign convergence of improbables: a sharp and sustained fall in the oil price. News that China has raised oil prices by up to 18 per cent sparked a fall in the oil price and a fillip in the dollar.
The balance of probability is that a demand slump will depress the oil price, triggering a strong relief rally in the dollar. That could be self-feeding if it is seen to contain the inflation threat and removes the prospect of a rise in US rates, enabling the Federal Reserve and the administration to concentrate on the continuing dislocation to growth caused by the credit crunch.
Without this prospect, the potential for currency market dislocation, particularly given the buck-passing that passes for G7 policy co-ordination, is considerable. In such an outcome, a debilitated dollar would be the least of our problems.
Bill Jamieson is executive editor of The Scotsman