Dollar Appears Safe For Now

The Federal Reserve's campaign to pump additional billions into ailing credit
markets is unlikely to hobble the U.S. dollar, at least not yet.
Faced with a struggling economy and a dysfunctional financial system, the Fed
has vastly expanded its own balance sheet, essentially creating money to fund a
variety of new programs. That includes the ones announced Tuesday, which will
lend money to support securities backed by credit-card and auto loans and also
buy debt issued by mortgage giants Fannie Mae and Freddie Mac.
The risk is that massive injections of cash by the Fed eventually could cause
rampant inflation, something that is bad for the dollar because it erodes a
currency's value. But some investors say the Fed will curtail liquidity -- by
raising interest rates, among other things -- well before that happens. And in
instances of similar policy moves to push money into the system, like in Japan
earlier this decade, the impact on the currency was ambiguous.
Tuesday the dollar weakened against the euro, the Japanese yen and the British
pound amid choppy trading for stocks. Late in New York, one euro bought $1.3067,
up from $1.2902 a day earlier. One dollar fetched 95.47 yen, down from 96.98 yen
on Monday. Selling the dollar on inflation fears is "premature," says David Gilmore of Foreign Exchange Analytics, a Connecticut research firm. "People will have to
determine that [Fed policy] is generating inflation before the currency is
attacked." Indeed, one of the major risks the Fed is trying to avert is a deflation
scenario -- a vicious cycle of falling prices and contracting credit.
The Fed's moves toward less-conventional measures to stimulate the economy are
partly because it doesn't have much room left to maneuver on interest rates. It
has already lowered the federal-funds rate to 1% and, although more cuts are
likely, zero is fast approaching.

For many observers, the Fed's approach now resembles Japan-style policy
earlier this decade, when Tokyo was pouring money into its economy to combat
stagnant growth and falling consumer prices. This strategy can involve a variety of tools, 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. Japan officially adopted this approach 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, according to a recent report by
BNP Paribas. Japan also sold yen to weaken the currency. Despite those efforts, the yen actually strengthened against a basket of currencies from early 2002 until early 2005, noted Derek Halpenny, a senior currency strategist at the Bank of Tokyo-Mitsubishi UFJ. In the following two years, however, the yen weakened significantly as capital exited Japan in search of better opportunities in an environment of robust global growth. Mr. Halpenny expects something similar to unfold in the U.S. and doesn't anticipate a weaker dollar over the next six months. "There are inflation risks, but that's the later story," he says. "We don't even know the depths of the current downturn."

The global context also will be critical to the buck's fortunes. With the
world economy heading toward recession, other central banks may end up following
the Fed's lead in bolstering their own malfunctioning financial systems. If
other countries also adopt measures akin to quantitative easing, then there is
much less reason for the dollar to weaken against those currencies.
In the end, say investors, the question of whether the Fed moves are negative
for the dollar will depend on your view of inflation over the medium term.
"As long as officials continue to emphasize that they will wind down the extra
liquidity as soon as feasible when markets start to normalize," the expansion of
the Fed's balance sheet is unlikely to cause runaway inflation problem, wrote
strategists at UBS on Tuesday. "Demand for [a] safe, liquid store of wealth will
support the U.S. bond market and keep the U.S. dollar afloat."
By late afternoon in New York, the U.K. pound rose to $1.5496 from $1.5148 a
day earlier, while the Swiss franc fell to $1.1853 from $1.1967.