The Dollar and Bernanke’s Reputation

Robert Novak’s column today argues that Wall Street speculation over Fed rate hikes “appears to be dead wrong.” Novak says Fed head Ben Bernanke is more worried about spiking oil prices causing recession than he is about inflation.

If Novak is right, the central bank is going to suffer a big credibility loss by not acting. Perhaps on word of Novak’s column, gold jumped $16 this morning to $889. The greenback itself fell.

In the May report released last week, U.S. CPI jumped six-tenths of 1 percent to 4.1 percent over the past year. It has been running around 4 percent for the past six months. Food and energy are the big drivers, with gas prices at the pump rising 21 percent annually over the past three months and food prices by 6 percent.

Oil is up $3 this morning to $138. In Europe, the May CPI came in at 3.7 percent, with ECB head Jean-Claude Trichet signaling another rate hike.

Bernanke recently said the Fed would “strongly resist” inflationary pressures. And he has talked openly about defending the dollar. President Bush and Treasury man Paulson have made similar sounds, including at this weekend’s G8 meetings.

Bond-market futures are pricing in a 100-basis-point rise in the Fed’s target rate over the next seven months. For the August meeting there is a 70 percent probability of a one-quarter-point rate hike. By this January the target rate is predicted to reach 3 percent. Currently it is 2 percent.

In the open market for Treasuries, the 2-year note is now yielding about 3 percent. Last March, it was only 1.35 percent. Many traders use the 2-year note as a proxy for the fed funds rate. The huge increase in the 2-year rate is signaling a stronger U.S. economy, somewhat higher inflation, and a series of fed rate hikes.

If market expectations are foiled by a passive Fed that fails to deliver on its promise of a stronger greenback and its much-touted pledge to hold down inflation, it is likely the dollar will tank once again and drive up oil prices to new record-high levels.

Mr. Bernanke surprised almost everyone with his tough statements on the dollar and inflation. But if Novak is right, and there is no Fed follow through, both the dollar and Bernanke’s reputation are really going to sink.

My thought? I believe the Fed should raise its target rate one-quarter of a point at its meeting next week. It would be the shot heard around the world. The greenback would surge, oil and gold would collapse, and a lot of investment liquidity would come into the U.S. economy.

Let’s see what happens.