No Wonder the Dollar Keeps Weakening

05/09/2011 3:00 pm EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

The lax US central bank is rowing against the global tide to the detriment of the depreciating greenback, writes Axel Merk of Merk Investments.

The Federal Reserve Open Market Committee (FOMC) recently announced it will continue to purchase government securities as previously announced (QE2), including reinvesting principal payments from its holdings.

The FOMC downgraded its growth forecast and acknowledged inflationary pressures have moved from commodity inflation to core inflation, yet it insists inflation remains too low. The Fed considers inflationary pressures to be transitory, but monitors the evolution of inflation and inflation expectations.

We may need to revise the meaning not only of the word “transitory,” but also of what "inflation expectations are anchored" actually means. Forward-looking inflation expectations, as priced into the markets, have moved up significantly since Fed Chairman Ben Bernanke’s Jackson Hole speech last August, when he lamented inflation was too low.

It appears to us that the headwinds caused by higher food and energy prices may be answered with a more accommodating monetary policy, given that the Fed confirms its loose policy may persist for an extended period.

In that context, it should be noted that the phasing out of QE2 is not an exit, but a pause. The banking system will remain awash in money, as seen in the extreme levels of excess reserves.

The trouble is that commodity inflation—and now, core inflation—may well be fueled by the policies pursued in the first place.

Bernanke argues that only equity prices rise because of his policies, and that global demand and other factors are largely responsible for food and inflationary pressures. With due respect, while the Fed cannot be blamed for all the ills in the world, the Fed must not deny that it plays a role in fostering inflation—all the more since the Fed's explicitly stated policy is to raise inflation.

As the Fed continues to ease, while all other major central banks with the exception of Japan’s are tightening, it would not be surprising if the US dollar continues to weaken. It turns out that this may be exactly what Bernanke wants, as he is firmly embracing the dollar as a monetary policy tool.

When a central bank wants higher inflation, that wish is likely to come true. Bernanke has referred to the "slack in the economy" and high unemployment as reasons to believe inflation will remain contained. We hope he is right, but cannot base our investments on hope.

Read more commentary from Axel Merk at the Merk Mutual Funds Web site here…

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