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Monday January 10, 2005 - 15:25:35 GMT
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Snow Connects the Dots...Deficit Reduction Means Stronger Dollar

Forex: Snow Connects the Dots...Deficit Reduction Means Stronger Dollar

The markets and even the ECB's Trichet (speaking for G10 central bankers after today's BIS meeting) are born again...there is a strong US dollar policy after all. Hallelujah. Praise the Treasury Secretary. On Friday John Snow said "We want to do things to sustain the strength of the dollar. Among them is going to Congress to bring the deficit down, to see that we restrain spending so that the deficit will be cut over the course of the next few years -- cut in half." And Snow never once said, in his CNBC interview, that FX rates are best determined by the market. Already reams of analysis has been written about the significance of this omission, as if Snow deliberately dropped this statement to signal the Bush administration no longer is indifferent to an orderly decline in the dollar.

No doubt Treasury Secretary Snow's remarks were significant and reflect the priority the administration has put on cutting the budget deficit in the second term. And by linking deficit reduction to supporting the dollar is no doubt an effort to address critics from European officials to market pundits who have called for higher US savings to stem the unsustainable growth in the US current account deficit. Snow connected the dots on Friday. He said the Bush administration is taking steps to increase US savings (government savings) and this will help support the dollar. But I doubt that Snow meant to say that because the dollar is weak the Bush administration is taking steps to address the budget deficit. The dollar is not wagging this dog. At most the dollar is a market signal that the deficit is unsustainable and will bring higher market interest rates and a weaker dollar absent policy measures from the Treasury and Fed to address low US savings. Rest assured that the Bush administration is not taking a view on the dollar per se that it has weakened enough, should stabilize or even rise. It is still very much of the view that markets should set the level of the dollar andm officials should not coerce markets into buying, selling or holding dollars. I doubt very much that on Friday Snow premeditatively decided that it was time to talk up the dollar.

Keep in mind too that last month Italian PM Berlusconi met with President Bush in the White House where the euro/dollar rise was a major point of discussion. Berlusconi was determined, and said so publicly, to convince the Bush administration that the declining dollar was a problem. What did Bush say? The very same thing that Snow said on Friday...the White House would work with Congress to reduce the deficits and "this will cause people to want to buy dollars." Bush also said monetary policy in the US is supportive of the dollar too (raising rates...will make US returns more attractive). So it is hardly a new concept in Washington that the Bush administration sees deficit reduction as dollar supportive. But in no way is the Bush administration suggesting that some forces other than the markets should set the level of the dollar. Are we to think that Snow parsed his comments like some central banker might to signal a shift in policy? Hardly. By omitting a preference for market determined FX rates, was Snow really saying that the dollar is weak enough and perhaps officials in G7 now need to intervene (verbally or physically)? I beg to differ.

Markets get myopic for sure, especially when the dollar bounce (or decline) is large and comments from top officials coincide with a significant move. We tend to ignore everything that has happened the Bush remarks in mid-December. Or for that matter the numerous public statements from Snow in December pledging deficit reduction would be a cornerstone of the second-term economic agenda. All Snow did Friday was what Bush did in mid-December...he connected the dots. Credible deficit reduction will lead to a higher dollar. But this is not an administration looking for a way to a stronger dollar. It is a by-product. I firmly believe that rising market rates (higher bond yields) is a far graver concern for this administration than a falling dollar and assuring foreign investors that the administration is dedicated to trimming the deficit is aimed at securing adequate foreign capital inflow. And yes, part of maintaining foreign confidence in US assets is assuring investors that currency risks are manageable. The Bush administration is surely committed to maintaining the strength of the dollar as is the Fed. And forecasts of a dollar collapse, from benign neglect are overstated.

Finally, the Bush administration is explicitly seeking a weaker dollar versus the yuan and any other Asian currency artificially held low with activist currency policy (intervention). At most the White House recognizes that the appreciation of the euro against the dollar (and European currencies) has been significant and benefits from further appreciation risk impeding capital inflows. But there is every reason to think the White House is eager to see China revalue and Asian currencies in general rise, including the yen if it follows a yuan revaluation. And as I suggested last week, the real question ahead on the extent for deficit reduction supporting the dollar is whether it is credible. Can we expect radical cuts in spending? Can we expect new revenue initiatives? Will expensive Social Security reform undermine budget savings measures elsewhere? Are the rising costs of homeland security and the war on terror budget busters? Can Bush even if he wants to get Congress to pass cuts in entitlement programs like Social Security and Medicare? Saying it is committed to deficit reduction does not make deficit reduction. Seeing is believing. If anything the Bush administration has forced the currency market (and maybe bond market) to link the future value of the dollar to budget deficit reduction. This could come back to haunt them if efforts meet resistance in Congress, stall or at worse fail. Moreover, we do not know the details of the plans and they may not even end up passing the smell test. We should know more of the details later this month with the President's budget due by February07 and two key addresses in January...January20 Inaugural Address and the yet to be scheduled State of the Union Address.

David Gilmore


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