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Politics Trumps Fed Policy

By John Tamny

Despite testimony last week from Federal Reserve Chairman Ben Bernanke suggesting that inflation remains the Fed's "predominant" concern, the dollar finished the week lower against the yen and Euro. The reason for the drop is the Commerce Department's announcement of new tariffs on coated paper imports from China. While not explicit, the move by the Bush Administration was a signal to the markets that it wanted a weaker dollar, and so the dollar fell accordingly.

The role of politics as it applies to the direction of currencies should not be discounted. Though central banks ultimately control money creation while nominally free of political influence, they have traditionally been outmaneuvered by the politicians, which raises questions about how effective future rate hikes will be when it comes to strengthening the dollar. History shows that central banks are often toothless versus the administration in power when it comes to setting the direction of currencies.

After President Nixon closed the gold window in 1971, Fed Chairman Arthur Burns was a passionate advocate for a return to fixed exchange rates "for the sake of our economy and for the sake of harmonious political relations with the rest of the world." In his notes, Nixon deemed Burns "unbearable" and imposed an import surcharge. The yen surged 17 percent against the dollar, and thus began the inflationary '70s.

Between January and July 1977, the Fed raised rates 100 basis points, but the rate hiking proved powerless against a speech by Carter Treasury Secretary Michael Blumenthal in June in which he said the dollar was overvalued versus the yen. Despite raising rates another 450 basis points by October 1978, the dollar's fall was only briefly arrested when the Carter Administration crafted a dollar-rescue plan with the help of central banks around the world.

As Stanford economics Professor Ronald McKinnon has noted, "Since 1978, Japanese long-term interest rates have averaged 3 to 4 percentage points less than American rates." The spread between short rates set by the Bank of Japan and the Fed is similarly wide, but neither has arrested the yen's long-term rise against the dollar.

Politics, trade politics in particular, explain the above conundrum. When he took over as Treasury Secretary in Ronald Reagan's second term, James Baker sought a weaker dollar under the false belief that it would lower America's trade deficit with Japan. Though our supposed trade imbalance with Japan continued to rise, Baker won currency concessions from Japan during the 1985 G5 meetings at the Plaza Hotel in New York, and while the short rate on money set by the Fed was 400 basis points higher than Japanese cash rates, the yen rose 41 percent versus the dollar over the next seven months.

During the early part of Bill Clinton's first term, protectionism reared its ugly head again in the form of a threatened 100 percent tariff on Japanese imports of luxury cars. Despite a 300 basis point spread on short rates between the U.S. and Japan, the yen surged 50 percent against the dollar (120 to 80/USD) amidst the threat, and only fell back to 120/USD when the Clinton administration moved away from its mercantilist actions.

Much is made of dollar weakness in recent years, but at 5.25 percent, the short rate on dollars is already higher than the rate targets for the Euro, British pound, yen, and Canadian dollar. Even though the Fed has hiked rates 425 basis point since June 2004, steel and lumber tariffs in 2002, persistent jawboning of China about the supposedly undervalued yuan, and further tariffs on shrimp and paper have made it clear that the Bush Administration speaks with a forked tongue when it comes to currency strength. Its actions on trade have regularly communicated to the markets a desire for a weaker dollar, which has has trumped any efforts by the Fed to strengthen it.

While serving British Prime Minister Margaret Thatcher as Chancellor of the Exchequer, Nigel Lawson observed that when his desire for a 3/1 deutschemark/pound rate became apparent, "the market started to do much of the stabilizing for us, selling sterling when it approached DM3 and buying sterling whenever it dipped below it." The lesson for the U.S. is that so long as the Bush Administration makes plain that it wants a weaker dollar, no amount of rate hikes by the Fed will overcome this reality.

John Tamny is an editor at RealClearMarkets. He can be reached at jtamny@realclearmarkets.com.

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