Rescuing dollar raises potential policy tug-of-war

Rescuing Dollar Raises
Potential Policy Tug of War

Treasury Intervention
Would Reduce Supply,
Undermining Fed Boost

By Craig Karmin
The Wall Street Journal
Tuesday, March 18, 2008

With the U.S. dollar tumbling to its lowest level against the yen since 1995 and hitting another record low against the euro, some traders and analysts wonder whether the Treasury Department may soon have to intervene to brake the currency's fall, something it was last forced to do in the mid-1990s.

But currency interventions have a mixed record of success around the world. In this case, if the Treasury decided to act, it might find itself moving in the opposite direction of an even more powerful market force: the Federal Reserve.

When a government intervenes in currency markets, it buys or sells a currency depending on the direction in which it wants it to move. In this case, the Treasury would be forced to buy dollars, constraining their supply, to slow or halt the pace of its decline.

When the Fed lowers interest rates, as it has been doing aggressively in recent months, it is effectively pumping dollars into the financial system.

When the Fed meets today, it is expected to reduce its target on the federal-funds rate by at least three-quarters of a percentage point, and perhaps by as much as a full point. That move could further pressure the dollar.

In addition to pumping extra dollars into the global financial system, it would increase the gap between U.S. and European interest rates, which makes holding foreign currencies more attractive to investors. The actions could also fuel investor fears that the crisis is deepening, further weighing on the dollar.

"I can't think of a time when the U.S. was simultaneously easing monetary policy and intervening in the currency markets," said Jeffrey Frankel, a professor at the Kennedy School of Government at Harvard University. The confluence of those two government actions, he added, would risk canceling each other. That could leave the dollar vulnerable to further declines.

The euro has increased 8% this year against the dollar, while the U.S. currency has declined by 12% against the yen. The dollar fell to 97.38 yen yesterday in New York from 99.32 yen late Friday. The euro rose to $1.5747 from $1.5671, and fell to 153.35 yen from 155.65 yen. The British pound was at $2.0007 from $2.0023, and the dollar fell to 0.9858 Swiss franc from 0.9990.

Analysts say any government intervention in the currency market that failed to achieve its goal of slowing the decline would be far worse than none at all. It would embolden speculators to increase their bets on the buck's fall, believing that governments couldn't stop them.

Stephen Jen, a currency analyst with Morgan Stanley said for government intervention to work, European monetary officials not only would have to coordinate with Washington and Tokyo in buying dollars on the open market, the European Central Bank also would have to change its stance on interest rates. At a minimum, he said, the ECB would have to shift its outlook on interest-rate increases to neutral from leaning toward further increases.

That may not happen until the ECB is convinced that inflation in the 17-nation zone is slowing from the 3.3% annual rate recorded in February. However, it is possible that the ECB could shift gears in anticipation of a slowdown, as it did in the middle of 2001, Mr. Jen added.

For investors who think the slowing U.S. economy and bubbling credit crisis indicate further dollar weakness, even intervention might not be enough to scare them off. "We would use it as a way to sell more dollars," said Jonathan Clark, vice chairman at FX Concepts, a hedge fund based in New York that specializes in currency trading.

Certainly not everyone in the U.S. government would favor currency intervention, in part for philosophical reasons that oppose intervening in the market. The weak dollar also has helped increase U.S. exports and has played a role in starting to reduce the massive current-account deficit.

But after six years in which the dollar's decline has been relatively orderly, in recent days the selloff has picked up speed alongside the collapse of Bear Stearns and heightened fears that the credit crisis is intensifying.

Even if the worst case doesn't materialize, the dollar's continued depreciation can increase U.S. inflation, push commodity prices higher worldwide, and undercut U.S. stocks and bonds by making them less attractive to foreign investors. That is why Mr. Jen said it is "prudent" for investors to start thinking about a coordinated intervention down the road, even though "conditions are not yet prime."

Interventions don't always work. In 1992 George Soros became known as the "Man who Broke the Bank of England" after his bets against the pound undercut government efforts to defend the currency and forced a devaluation.

But they also have marked important turning points in currency markets in the past. The Plaza Accord in 1985 successfully stemmed a powerful dollar rally against the yen and the German mark, while the Louvre Accord two years later helped stop the dollar's decline.

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