When Federal Reserve Chairman Ben Bernanke on Friday outlined the case for further quantitative easing measures amid low inflation and high unemployment, it is possible he (or his speech writers) had early knowledge of the Cleveland’s Fed latest monthly estimate of 10-year expected inflation at 1.53 percent, which was released later in the day.
In his speech, Bernanke said “the risk of deflation is higher than desirable … in light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation — setting aside the inevitable short-run volatility — will be less than the mandate-consistent inflation rate (2.0 percent or a bit below) for some time.”
Looking at the Cleveland’s Fed updated expected inflation, it’s a fact the number continues to trend worryingly lower while remaining stubbornly below the 2 percent level that is considered as consistent with the Fed's mandate while unemployment is approximately twice the level that is considered as consistent with the Fed's mandate.
In this context, it’s understandable Bernanke argues that further monetary easing is warranted.
Also keep in mind his statement when he says: “A step the committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the committee expects to keep the target for the federal-funds rate low for longer than the market expected.”
For investors, I would consider this as a clear warning: “Don’t fight the Fed,” at least not now.
No doubt there are extremely complex implications for the dollar’s value in the future, medium-term and later. For the foreseeable future, we will continue to see negative U.S. interest-rate differentials with practically all important countries in the world.
Besides that, all quantitative easing (QE) measures are negative to any currency's value where its central bank applies it.
But, for the time being at least, there also is no serious substitute for the dollar as the world’s reserve currency — and that will remain a privilege for the dollar for longer than most people think these days.
Interestingly, we note that the Federal Open Market Committee (FOMC) has become increasingly sharply divided on the efficacy of QE measures as QE1 apparently didn’t fulfill their expectations, not by a long shot.
Anyway, I don’t think it’s an overstatement to say that Bernanke has effectively rolled the dice on his own legacy.
Let’s hope, and I mean it, that his announced QE2 measures, whatever size and form they could take, actually do boost U.S. inflation, otherwise the U.S. is on its irrevocable way to following Japan down the same deflationary hole that it has been in since the mid-1990s.
Unfortunately, long-term investors should also keep in mind there are limits to monetary policy as Bernanke himself has pointed out at several occasions.
All this doesn’t mean that the dollar couldn’t move up again from its oversold situation where it is now. Don’t forget, dollar up means practically everything else down, and vice versa.
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