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Jewish World Review July 20, 2001/ 29 Tamuz 5761

Lawrence Kudlow

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Currency crunch

http://www.jewishworldreview.com -- THE turmoil in foreign exchange markets spreading from the Southern Cone of South America to Eastern Europe and Southeast Asia exposes the growing risks to global capital markets arising from the Fed's continued inability to overcome a deflationary scarcity of dollar liquidity.

As monetary authorities from Brasilia to Warsaw and Singapore -- and many points in between -- wage a largely futile battle to keep their currencies from sinking to new lows against an ever-appreciating dollar, the Fed's culpability is almost entirely overlooked. In echoes of the crises of 1997-98, one again hears of "contagion" infecting emerging market currencies, as if an exotic strain of financial virus has been released into the markets at random. Like that earlier episode, however, the common thread running through the turbulence now affecting the emerging markets is the Fed's squeeze on dollar availability.

This is seen first in deflation of the prices many commodity producers rely on to service their dollar-denominated debt. The problem is compounded as dollar debtors, seeking to hedge their exposure in increasingly risk-averse conditions, sell short their local currencies against the dollar. This defensive action drives the dollar higher still as the Fed fails to satisfy the overseas dollar demand.

It is some consolation that two separate pieces in Sunday's New York Times, including the front-page lead, called attention to the high-flying greenback as a factor that could hinder U.S. economic and equity market recovery, particularly due to its impact on export volumes and exporter profits. As to how the currency could be continuing to reach new 15-year highs, even in the face of 275 basis points in Fed rate cuts, the reports could only offer that the dollar remains a "safe haven" in uncertain times.

That tells only half the story, though, as the dollar is in fact a "safe haven" from the strains being created in the first place by the currency's excess scarcity. The global dollar shortage is surfacing in the Fed's liquidation of custody holdings for foreign central banks. As the central banks are forced to cash in their dollar-denominated assets to satisfy demand for scarce greenbacks against their home currencies, the Fed's portfolio of official dollar holdings has contracted on net by more that $20 billion since mid-March. In retrospect, similar forced liquidations of dollar reserves ended up as telling precursors of sharp downdrafts in the deflation-induced financial panics of '97 and '98.

Whether or not another such financial firestorm lies in store, the Fed's open-market operations give rise to serious doubts as to whether its current stance can be considered an "easing" of liquidity conditions in any real sense -- as a more abundant supply of dollars relative to demand. Overall, the Fed's balance sheet assets have been growing year-over-year at a rate of about 5%. That's an improvement on the negative growth rates earlier in the year, when year-to-year comparisons were still dominated by the Fed's Y2K liquidity bulge. But the recent trend is still down from the balance sheet expansion of more than 7% a year ago, in the aftermath of the Fed's final rate hike in its 175-basis point tightening cycle.

Certainly, sensitive market indicators of the Fed's liquidity posture show little evidence of more ample supply relative to demand. In fact, at around $266 per ounce, gold has retreated by some $10/oz. from its levels just prior to the June 27 FOMC meeting, and is now back below levels seen at the initiation of the Fed's rate-cutting exercise in early January. A steady decline in broad commodity indexes confirms gold's deflationary signal.

What's the solution? The Fed and Treasury should work together to stabilize the dollar's exchange rate index around current levels. For its part, the Treasury should publicly announce its support for a stable -- but not stronger -- dollar index. At around 120, by the way, the trade-weighted G-7 dollar index is up about 10% so far this year.

Then the Fed should back up this policy with a faster rate of dollar creation. This would mean an 8% - 10% expansion rate for Federal Reserve credit (or the monetary base), the central bank's basic liquidity measure. Given the current weakness in private credit demand, a step-up in base growth would be consistent with a funds rate settling around 3% to 31/4%, down from today's liquidity-restraining rate of 3 3/4%.


JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.

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