AL OFFICIALS who spent us into oblivion and did nothing to stop the outflow of jobs for years.

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After muted decade, beware dollar-inflation link

05-12-06

By Mike Dolan: Economics Correspondent - Analysis

WASHINGTON (Reuters) - Even though U.S. import prices, excluding pumped up energy costs, were almost flat last month, experts warn policy-makers to ignore the inflationary impact of a falling dollar at their peril.

The dollar has fallen 6 percent versus a basket of the world's "major" currencies since March, according to a Federal Reserve index monitoring the dollar against the euro, yen, sterling plus Canadian, Swiss, Australian and Swedish units.

The dollar had risen against most freely traded currencies through much of 2005 as the Fed steadily nudged up interest rates, but lost steam as the year ebbed. And analysts say the dollar now looks set to resume its steep decline of the 2002-2004 period -- when it lost some 30 percent over those two years.

On the Fed's "major currency" index, it is now less than one percent from its lowest point in the post-1973 floating exchange rate period. That low was in April 1995 and one which prompted concerted central bank intervention from the Group of Seven industrial powers to lift the sliding greenback.

The dollar has also fallen some 4 percent since the start of April against the Fed's broadest basket of currencies of America's biggest trading partners, including China and emerging Asia.

But, although the dollar's impact on import prices has been remarkably muted in recent years, some economists say this benign period of low, so-called "pass-through" may be ending.

"Further significant dollar weakness at this juncture likely would escalate both inflation expectations and, courtesy of rising import prices, inflation itself," said Richard Berner, chief U.S. economist at Morgan Stanley.

"That would mean the Fed still has more work to do," Berner told clients in a note this week, referring to speculation the Fed may pause in its long campaign of rate rises after hiking its benchmark rate a quarter percentage point to 5 percent this week.

PASS-THROUGH IN THE PAST?

Economists have marveled for years at the relatively muted impact of recent currency fluctuations on industrial countries' import prices and consumer inflation over the past decade.

Traditionally a falling dollar would boost the dollar price of imports from Europe or Japan, for example, as firms adjusted final prices to reflect exchange rate movements.

The hefty share of imports in most U.S. consumer goods baskets would then mean this tended to lift overall inflation.

What is more, over time, policy-makers have also hoped this would prompt households to switch from increasingly expensive foreign-made goods to homespun ones and help narrow the country's worrying record trade deficit.

But globalization of production, fierce competition for market share in the consumer-driven U.S. economy and the entrenched credibility of monetary policy have all been cited as factors that have muted the pass-through of currency shifts to the final price of goods in the shops.

Fed research papers released in January, for example, show exchange rate pass-through within the G7 countries declined sharply over the past decade. They concluded a 10 percent drop in the local currency would have increased import prices by nearly 7 percent on average in the late 1980s but only 4 percent in the past 15 years.

Fed Chairman Ben Bernanke seems to subscribe to this view, economists said, as well as believing explosive commodity price rises -- where industrial metals have doubled in price over the past year alone -- are of little worry to final inflation.

"We disagree with that view," said Dean Maki, chief U.S. economist at Barclays Capital. "This is a very different environment than that seen in recent years."

ROSY DAYS ARE OVER

As the dollar slides anew, and with the U.S. Treasury effectively advocating its decline against China's yuan and other emerging Asian currencies, the fear is that exchange rates may once again start to bite on prices.

Berner at Morgan Stanley cites four reasons why he thinks a fresh bout of dollar weakness at this stage of the U.S. business cycle will hit home harder than it has for years.

First, because the speed of the current dollar decline is faster than in the 2002-2004 period, it could catch unhedged producers off guard and force U.S. importers or foreign exporters to the United States to pass on much of the dollar price increase to consumers.

Second, he said spare capacity in U.S. product and labor markets has ebbed significantly. Third, a global economic boom of around 4 to 5 percent growth per annum for the past four years is eating away economic slack worldwide.

And finally, U.S. inflation expectations -- measured in consumer polls and bond markets -- are already heading higher.

"The cyclical reduction in economic slack suggests that...a further 10 percent decline in the dollar on a trade-weighted basis would help push U.S. core inflation in terms of the PCE index toward 2.5 percent," said Berner.

The index of personal consumer expenditures excluding food and energy, seen as the Fed's favored measure of inflation, rose 2 percent in the year through March. The Fed's perceived "comfort zone" for annual growth in this index is 1-to-2 percent.

"We do not view the explosive increases in commodity prices and the decline in the dollar as benignly as Chairman Bernanke," said Maki at Barclays.