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Major central banks seen tolerating gradual dollar decline, but no ‘brutal’ moves

Joseph Lazzaro
Blogging Stocks [1]
Monday, Oct 6, 2008

With passage of the rescue bill, and the U.S. Treasury’s upcoming actions to stabilize credit markets through a variety of tools/mechanisms, one area that is likely to experience negative consequences is the dollar.

Simply, more dollars borrowed (or more dollars printed) almost always means each dollar is worth less. Economist Richard Felson said a gradual, orderly decline in the dollar “would be expected, and is almost considered the default response, given increased U.S. government borrowing.” The dollar closed Friday down about one-half cent to $1.3775 and $1.7713 versus the euro and the British pound, respectively.

Central banks monitoring dollar’s level

However, leaders of the world’s major industrialized economies will not, in Felson’s interpretation, accept a sudden and/or inordinate decline in the dollar. “Along with increased stress on the financial system, ‘brutal’ currency movements, as [European Central Bank President Jean-Claude] Trichet has said, throws everything out of whack by making it hard for companies to project costs of foreign operations,” Felson said. “For these reason and others I believe the major central banks will intervene to support the dollar, should the U.S. Treasury’s extra borrowing or the U.S. Federal Reserve’s extra lending for the bailout lead to too large or too quick of a decline in the dollar.”

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Meanwhile, the dollar bulls — those who believe the dollar will rise — say a fall in the dollar from the rescue package is not guaranteed. There will be more U.S. government borrowing and/or more dollars in circulation, the bulls say, but there also is a simultaneous rush by banks and other institutions to acquire — and hoard — dollars to rebuild capital reserves and beef-up balance sheets, which will support the dollar. A flight-to-safety will also support the dollar, the bulls say, because, despite all of its nation’s problems, the dollar remains the world’s reserve currency.

  • A d v e r t i s e m e n t

Still, Felson says its hard to envision a dollar remaining the same value with a budget deficit for this year, fiscal 2009 of at least $438 billion, not counting the Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) takeovers, the Fed’s $85 billion loan to American International Group (NYSE: AIG), or the costs of the rescue bill.

Given, the above, Felson believes the world’s major central banks — the Fed, ECB, Bank of Japan, Bank of England, Swiss National Bank, and the Bank of Canada — will be at the ready to intervene and support the dollar, as needed.

The last coordinated intervention to support a currency occurred in 2000, when the world’s major central banks intervened to support the euro. Felson sees strong, regional incentives for Japan and the E.C.B. to support the dollar, as it will make their exports more-competitive on a price basis.

Forex/Economic Analysis: Economist Felson added that the globalization era, and the increased wealth it has created in developing countries, means that central banks in Brazil, Middle East economies, and perhaps Mexico may be in a position to support the dollar, as well, although Felson does not believe their participation is necessary to keep the dollar at an acceptable level.