Bernanke Changes Strategy

Before World War I, Germany pondered how it might fight and win a war on two fronts. The nation’s leaders concluded that they must defeat France before Russia could mobilize and then deal with Russia.

The Federal Reserve has been conducting a war on two fronts -- slow growth and inflation -- for many months with a similar strategy. For the first part, the Fed attempted to defeat slow growth. On Tuesday, Fed Chief Ben Bernanke effectively announced that the Fed is done battling slow growth and will now bring the fight to inflation. Hopefully, slow growth is whooped.

Bring on the inflation battle
Bernanke spoke via satellite to the International Monetary Conference in Spain on Tuesday. Making it clear that the Fed wants the dollar to strengthen, he said the weakness in the dollar has caused an “unwelcome rise in import prices and consumer-price inflation.” He also indicated that the Fed is done cutting rates. The dollar rallied on the news.

The Fed has been trying to stave off recession for a while now. Since just last summer, it has lowered the discount rate from 5.25% to 2%. The Fed also took an unprecedented role in supporting and providing liquidity to the mortgage-backed market with its role in the JPMorgan Chase (NYSE: JPM  ) buyout of Bear Stearns. While battling recession and potential economic disaster, the Fed barely even acknowledged the inflation threat.

What's with the Fed talking about the dollar?
The Fed typically doesn’t attempt to influence dollar valuations. This speech marked a significant reversal in policy. Just this past February, Bernanke was saying that “the Treasury is the spokesman for the dollar.” Before this speech, he had referred to the weak dollar only in terms of its positive effect on exports. His choosing to focus on the dollar indicates that he thinks a strong dollar is crucial to prevent inflation.

A weak dollar is a double-edged sword. It’s great for exports because it makes U.S. goods cheap and thus favorably affects our balance of trade. A weak dollar is great news for companies that sell a lot overseas, such as Boeing (NYSE: BA  ) and eBay (Nasdaq: EBAY  ) , as well as for big multinationals such as Procter & Gamble (NYSE: PG  ) or Coca-Cola (NYSE: KO  ) . However, it has the reverse effect of making imports expensive and causing inflation. This is especially true with regard to our most conspicuous import, oil.

This week’s speech from Bernanke put the markets on notice that the Fed is now actively pursuing a stronger U.S. dollar. And how will it fight the sliding dollar? Probably just with words. The problem is that the Fed has only a couple of tangible ways to strengthen the dollar, and both are undesirable at this point. First, it can raise interest rates. But that move might slow an economy that is already sluggish from the housing slump. The Fed could also buy up the greenback in the open market. However, this practice is unpredictable and could actually have the reverse effect.

How to strengthen the dollar
Talking the dollar stronger might be all that is necessary. Between the start of 2002 and this last spring, the dollar has fallen more than 40% against the euro and 26% against the yen. Many believe that the sell-off in the dollar has been overdone and that it may be close to the bottom; conventional wisdom among many prominent currency traders is that the dollar is poised to rally.

Bernanke may be trying to defuse a bomb that will end up exploding anyway, but his words could also be just the nudge that the dollar needs. A stronger dollar could save us from inflation or stagflation.

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JPMorgan Chase is a Motley Fool Income Investor selection. Coca-Cola is a Motley Fool Inside Value pick. eBay is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tom Hutchinson holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.

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  • Report this Comment On June 06, 2008, at 8:11 AM, pondee619 wrote:

    " Germany pondered how it might fight and win a war on two fronts...

    The Federal Reserve has been conducting a war on two fronts ...with a similar strategy"

    How did that work out for the Germans?

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