Why the Dollar's Rebound Will Be Short-Lived

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The dollar yesterday (Thursday) rallied from 14-month low against the euro, but that rally will be short-lived as U.S. monetary policy is likely to remain loose, even as other central banks raise interest rates.

A recovery of investor risk appetite has slammed the dollar in recent months, driving the currency to a rate of $1.5017 against euro on Wednesday, compared with $1.25 in March. But yesterday, analyst Dick Bove's downgraded outlook for Wells Fargo & Co. (NYSE: WFC) and China's less-than-stellar third-quarter growth spurred a greenback recovery.

The euro fell as low as $1.4944 against the dollar in early morning trading, as investors became more skeptical of the global economic recovery. Still, many analysts believe the dollar will rather hastily resume its decline.

"The euro's proximity to $1.50 suggests that the market is not taking the current correction as too serious," Michael Klawitter, senior currency strategist at Commerzbank in Frankfurt told CNNMoney. "Quite a few investors are buying euros on dips."

And they have good reason to because despite having a so-called "strong dollar policy,"
U.S. policymakers understand that a weak dollar is benefiting the economy by keeping liquidity high and boosting exports.

The Fed's Weak Dollar Policy

The Reserve Bank of Australia earlier this month became the first developed economy to tighten monetary policy. Canada, which has shown signs that it is emerging from the economic downturn faster than the United States, may be next. And now China – whose gross domestic product (GDP) expanded by 8.9% in the third quarter – is turning its attention from economic expansion to inflation, as well.

"The policy focus of the next few months is to balance the need to maintain stable and relatively fast growth, the need to adjust the economic structure and the need to better manage inflationary expectations," China's State Council said in a statement signaling a looming policy shift.

However, it's a far different story in the United States where price pressures remain low and the recovery remains mild.

After contracting by 6.4% in the first three months of the year, the U.S. economy shrank by a revised 0.7% in the April-June period. But analysts remain skeptical, given the soaring unemployment rate and moderate effects of the Obama administration's stimulus.

About 7.2 million jobs have been shed since the recession began in December 2007, driving the unemployment rate to 9.8% in September. Some economists estimate that the jobless rate could peak as high as 10.5% next summer.

Meanwhile, the President Obama's $787 billion stimulus plan – which the administration claimed would keep unemployment below 8%, and push it below 7% by the end of 2010– has brought little stability to the job market.

Only about a quarter of Obama's stimulus, or $164 billion, has been paid out. About half, nearly $400 billion, will be paid out over the next 12 months in the build-up to mid-term elections, and the remainder will be disbursed in 2011.

Indeed, the outlook for a quick recovery in the United States is dim, which means the U.S. Federal Reserve will almost certainly maintain its expansive monetary policy until it sees more progress.

In fact, Federal Reserve Bank of St. Louis President James Bullard last week said that a falling unemployment rate is a precondition for an increase in the benchmark interest rate from near zero.

"You want some jobs growth and unemployment coming down," Bullard said in an interview with Bloomberg Radio. "That is a prerequisite" for an increase in interest rates.

The Fed's Beige Book, which was released Wednesday, offered even more justification for the dollar's downward trajectory.

All 12 district banks observed "little or no" price pressures, while demand for bank loans was "weak or declining."

"The Fed Beige Book confirmed the absence of pricing pressure in the United States and activity was merely starting to recover from depressed levels – thus the Fed is showing no signs of removing the punchbowl of low rates," analysts at ING said in a research note. "Thus core trends remain intact and USD rallies should be sold into."

Indeed, the Fed actually has a lot of short-term incentive to keep interest rates low and the dollar weak.

To begin with, a cheaper dollar makes U.S. exports more affordable to the rest of the world. And that has helped to shrink the U.S. trade deficit.

The U.S. trade deficit shrank by 3.6% in August to $30.71 billion from a downwardly revised $31.85 billion the month before. The July trade gap was originally reported as $31.96 billion.

It's true that a drastic drop in the value of the dollar would make imports much more expensive for U.S. consumers and make it more expensive for the government to finance debt. But some analysts argue that so long as the dollar's decline doesn't turn into a rout, it actually benefits the economy.

"As long as it doesn't crash, a gradual, orderly decline is healthy," C. Fred Bergsten, director of the Peterson Institute for International Economics, told The New York Times. "The dollar went up 40% between 1995 and 2002, so this is a necessary rebalancing."

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