Weak dollar may be 'checkmate' for the Fed

ANALYST'S VIEW

When the Federal Reserve talks about the risks to the economy, be it slower growth or higher inflation, it's usually an either/or proposition.

What if it's both? What if the US economy is facing the prospect of slower growth and higher inflation, a dual diagnosis requiring offsetting actions for each symptom? Certainly that's where the risks lie, as Fed Chairman Ben Bernanke pointed out in congressional testimony last week.

"The Committee recognised that risks remained to both of its statutory objectives of maximum employment and price stability," Bernanke said, explaining policy makers' outlook at the conclusion of the October 30-31 meeting.

Bernanke enumerated the "downside risks" to the Fed's already slow-growth forecast: a deterioration in financial market conditions; a further tightening of credit standards; a steep decline in home prices that depresses consumers' willingness to spend; and a deceleration in business investment in response to a dimming economic outlook.

As for inflation, it's the usual suspects that pose a risk, according to the Fed chief: the soaring price of oil and other commodities and the decline in the foreign exchange value of the dollar. These price changes may be symptoms, not causes; they may be relative price shifts (in the case of commodities), not inflation per se.

The Fed doesn't elaborate on how it views the cause-effect relationship between policy and prices. So how big an impediment is the weak dollar to the Fed's best laid plans for averting a recession? Economists are of two minds (only one mind per person) on the dollar's impact on inflation and monetary policy going forward.

"It's 'check' for the economy now; it's facing 'checkmate'" says Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago. "Checkmate is the dollar. Bernanke's problem is that if he cuts, the dollar will go down even more. He may not be able to provide as much support for the economy as his predecessor."

That's not good because, if Kasriel's correct, the economy is showing signs of moving toward recession: two months of soft chain store sales; an increase of 0.1 per cent in real consumer spending in September; a "loss of altitude" in the Institute for Supply Management's manufacturing index; and a sharp decline in consumer sentiment, with the University of Michigan's expectations index down 22 per cent in the past year.

(The author is a Bloomberg News columnist.)