Wall Street Journal

With Rates near 0%, Dollar is Dumped

December 17th, 2008

The U.S. dollar took a beating, as the Federal Reserve's move to slash interest rates to nearly zero unnerved currency investors.

With the target for the key U.S. interest rate now between 0% and 0.25%, the dollar tumbled against the euro, the British pound and the Japanese yen. The dollar has weakened 8.5% versus the euro over the past week, marking a reversal of its strengthening trend in recent months.

The Fed's move into uncharted territory on Tuesday may be essential to lifting the U.S. economy out of danger. But they carry their own consequences, say currency investors, in particular undermining the appeal of holding instruments denominated in dollars.

"By being so aggressive, the Fed has really signaled significant weakness in the U.S. economy," said Robert Catalanello, head of foreign exchange for the Americas at Calyon in New York. "As a result, why do you want to hold the currency, really?"

On Tuesday, oil prices fell even as the dollar weakened.

The U.S. now has the lowest key interest rate in the industrialized world, lower even than in Japan, where it is 0.3%. That means investors have little incentive to hold short-term interest-bearing instruments that are denominated in dollars, encouraging them to sell dollars in favor of other currencies.

By cutting interest rates almost to zero, the Fed has effectively used up typical methods for stimulating the economy. Instead, it is resorting to a strategy used in Japan earlier this decade.

This strategy can involve a variety of measures, but is generally referred to as "quantitative easing," because it tackles the quantity of money in the financial system rather than its cost -- in other words, the interest rate. It also translates into an increasing supply of U.S. dollars, potentially putting pressure on the currency because of an oversupply.

As long as the decline doesn't get out of control, a weaker currency can be an economic palliative, since it makes U.S. exports more attractive to foreign markets. Indeed, Japan actively encouraged a weaker yen during its experience with quantitative easing.

In a 2002 speech before he became Fed chairman, Ben Bernanke described President Franklin Roosevelt's policy to devalue the dollar as "an effective weapon" against deflation during the Great Depression. He added that he wasn't forecasting or recommending such a move.

Japan officially adopted "quantitative easing" in early 2001, pushing money into the system through a number of measures, including direct purchases of Japanese bonds, asset-backed securities and even stocks.

Like Japan, the Fed has expanded its own balance sheet, essentially creating money to fund a variety of new programs. Tuesday it said it would expand its purchases of debt, and even consider buying U.S. Treasury bonds.

But investors worry that these policies eventually could cause rampant inflation if the economy shows any signs of recovery. That is bad for the dollar, since inflation erodes a currency's value.

"This is a real attempt at overwhelming force here," says Alan Ruskin, chief international strategist at RBS Greenwich Capital. The problem, he says, is that the Fed is moving toward a type of policy that is "absolutely impossible to calibrate."

While the European Central Bank also has lowered its key interest rate, it has been far less aggressive than the Fed. European policy makers also have cautioned investors not to expect further drastic interest-rate cuts. That is in turn buttressing the euro against the dollar.

Late Tuesday in New York, the euro was at $1.4128 from $1.3691 late Monday, while the dollar was at 88.78 yen from 90.79 yen. The U.K. pound was at $1.5629 from $1.5277, and the dollar was at 1.1178 Swiss francs from 1.1594 Swiss francs late Monday.


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