The Death of the Dollar: Will the Fed Kill the Greenback at Tomorrow's FOMC Meeting?

Months or years from now, when analysts are studying the death of the U.S. dollar, they'll look back and see that the greenback's demise began on a specific day - Wednesday, April 27, 2011.

As in ... tomorrow.

At 12:15 p.m. tomorrow, at the conclusion of a two-day Federal Open Market Committee (FOMC) meeting, we'll find out whether U.S. Federal Reserve Chairman Ben S. Bernanke and his policymaking posse opted for a sharp increase in U.S. interest rates - which appears to me to be the only solution to a looming third-quarter crunch.

Unfortunately, I don't think that Bernanke & Co. will make the needed move.

And without that sharp rate increase tomorrow, investors can look forward to rampant inflation, an evisceration of the U.S. Treasury bond market and - in a worst-case scenario - the death of the dollar.

Let me show you why....

It's Time to Worry About the Death of the Dollar

For the last two years, the U.S. economy has been supported by the twin catalysts of fiscal and monetary stimuli.

Fiscal stimulus seems likely to continue for some time yet - even the most avid Tea Party budget cutters don't see their way to cutting more than $100 billion or so off this year's $1.6 trillion deficit.

But monetary stimulus is another matter.

The Fed's so-called "QE2" (quantitative easing/second round) purchases of U.S. Treasury bonds are supposed to come to a sharp end on June 30. That makes July a crucial month - for the American economy, for the country's bond markets and, most of all, for the performance of the dollar.

These crucial monetary-policy issues will be reviewed at the two-day policymaking FOMC meeting that begins today (Tuesday) and concludes tomorrow. Policymakers are expected to leave the benchmark Federal Funds target rate in its current range of 0.00% to 0.25%.

If Bernanke wants to devise a "QE3" to follow his QE2, he needs to do it now: The next FOMC meeting is in late June, which is far too close to the expiration of QE2.

The decision as to whether to end quantitative easing - or to extend it - will be a tough one, made no easier by the fact that there is a substantial-and-growing group in the FOMC that did not like QE2 and that will strongly resist a QE3.

This "anti-easing" contingent has a strong case - and its arguments will be bolstered by figures that show inflation taking off.

Bernanke can resist these arguments for a time - either by focusing on "core" inflation, which excludes food and energy, or by looking at the "Personal Consumption Expenditures" (PCE) deflator, which is reported a couple of months in arrears. However, even with only one additional set of data from the present, he may find it difficult to argue that inflation is no longer a problem - in which case QE3 will be impossible to launch.

And without QE3, the U.S. Treasury bond market will be in real trouble.

The Looming Third-Quarter "Crunch"

Since QE2 began in November, the Fed has been buying about two-thirds of the Treasury bonds issued - or about $600 billion of the $900 billion in total bonds to be issued between November and June.

April is a particularly favorable month for the government: Because of individual and corporate-tax payments, the net issuance this month may be around zero. July through September, on the other hand, will be big months for T-bond issuance - at least $150 billion per month is needed.

It could be a tricky time, however. Credit-rating heavyweight Standard & Poor's has threatened to cut the United States' top-tier credit rating: But Japan, the world's second-largest buyer of U.S. Treasuries, isn't likely to be in the market much at that time, as it will need the money for its own reconstruction program.

Hence, expect to see a third-quarter crunch in the American Treasury market. The crunch will be made worse by the acceleration in inflation that is likely to occur between now and then: If inflation is running at, say, 0.50% per month - the equivalent of 6% per annum - by the summer, a 10-year Treasury bond yield of 3.5% will look untenable.

And so will a Federal Funds rate that remains close to zero.

The bond market won't be the only one to experience pain. The crunch we're predicting will also put a serious hurting on the currency market - specifically on the U.S. dollar.

If the U.S. government is trying to raise money that the markets don't want to give it, the U.S. dollar will decline on international exchanges, because of the continuing U.S. balance-of-payments deficit.

Thus, a third-quarter Treasury bond crisis is likely to go hand-in-hand with a third-quarter dollar crisis, as markets start to treat the United States as they would the European "PIIGS" (Portugal, Ireland, Italy, Greece and Spain). Despite their struggles, most of those countries have sounder budget policies than this one, and all of them have sounder monetary policy, thanks to the European Central Bank (ECB).

Simply extending QE2, as Bernanke almost certainly wants, won't solve this problem. The Fed would then be buying both too much debt and not enough.

You see, Treasury bond purchases of $75 billion a month would be enough to push inflation sharply upwards: This is, after all, the very same policy that gave the German Weimar Republic its trillion-percent inflation. (See the accompanying graphic: "A Grim Reminder.")

On the other hand, even if the Fed buys $75 billion of Treasuries a month, the summer months will bring with them the need to place an additional $75 billion worth of bonds every month. And with inflation rapidly accelerating, the chances of a bond market and dollar crisis would still be great.

The One Way to Avoid the Death of the Dollar

With the U.S. market straining under the burden of rising inflation and some ill-advised monetary and fiscal moves, the death of the dollar is looming as a worst-case - but still possible - scenario.

The Fed has one chance to avoid this outcome.

But it has to act tomorrow.

Just to have a chance of staying level with inflation. U.S. central bank policymakers must boost short-term interest rates at least to the 3% level. That would burst the global commodities bubble, and reduce inflationary pressures.

With that accomplished, the Fed could then - if Bernanke & Co. wished - continue with a "modified QE3." For instance, perhaps it could buy $50 billion of bonds in the third quarter and $25 billion in the fourth quarter, thus breaking the Treasury bond market off its "Fed-bond-purchase fix," instead of making the market quit "cold turkey."

With inflationary pressure reduced by the interest-rate increase, the chances of a Treasury-bond-market meltdown would thus be reduced to almost zero. Interest rates would rise and bond prices would decline, but in an orderly manner. And inflation, if it continued, would do so at a more-moderate pace.

In fact, even inflation - should it remain stronger-than-desired - could be moderated, simply by raising rates a bit more, perhaps in several increments.

And the U.S. dollar would be saved.

There's only one problem with this scenario: I don't think it will happen. Bernanke won't boost rates. And we'll be back here sometime in the future, writing the epitaph for the death of the dollar.

News and Related Story Links:

• Money Morning Commentary:
  Inflation Fears: A Sanguine Fed is Underestimating the Escalating Threat
• Money Morning News Archive:
  News Stories About QE3.
• Federal Open Market Committee:
  2011 Meetings Calendar.
• Wikipedia:
  European PIGS (PIIGS).
• The Wall Street Journal:
  Bernanke To Field Questions For About 45 Minutes Wednesday.
• Wikipedia: The Tea Party.
• European Central Bank:
  Official Website.
• Money Morning News Archive:
  Quantitative Easing News Stories.
• Investopedia:
  Personal Consumption Expenditures.
• Money Morning "Question of the Week" Feature:
  Does the United States Still Deserve its "AAA" Credit Rating?
• Money Morning News Analysis:
  Rate Hikes by Foreign Central Banks Could End the Party for U.S. Investors