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A Down Dollar's Lure -- and Peril

By Will Rugg A strong dollar relative to other major world currencies has long been the mantra of U.S. policymakers. But support for a muscular greenback has eroded during the Bush Presidency, and Treasury Secretary John Snow virtually winked and threw in the towel on May 18, when he suggested that the strong-dollar concept had little to do with current exchange rates.

Commenting during a summit meeting of the Group of Seven (G-7) major economic powers, Snow seemed to shift the strong-dollar policy's emphasis to upholding global confidence in the greenback as a store of value, also presenting it as a currency that can't be counterfeited. His comments were vague, but whatever they meant, he coupled his pronouncements with an assertion that dollar losses have been only "modest" to date. His words were quickly taken by traders as a green light to sell the greenback.

QUICK RELIEF. The Administration's apparent aim is to provide some short-term benefit to U.S. exporters (and possibly disadvantage Japanese and European exporters). A weaker dollar helps make U.S. goods cheaper to foreign buyers and causes imports to be more expensive relative to domestically produced goods and services. But an unintended consequence may result if the Administration isn't careful: less investor interest in U.S.-dollar denominated assets if American budget deficits continue to grow and a full-fledged recovery doesn't kick in soon.

Snow's latest comments aren't being read as merely benign neglect. They're being interpreted as U.S. officials' support and encouragement for a weaker dollar right now. Small wonder that in early trading on May 19, the European common currency surged, and the greenback fell from $1.155 per euro to $1.17.

In addition to helping U.S. exports, the Administration seems to be counting on a weaker currency to ward off deflation. That would give big companies some breathing room to raise prices on their products. And for now, Snow & Co. apparently aren't too worried about any fallout for U.S. assets. Until these most recent comments, Team Bush's tepid support for a strong dollar appeared to be paying off, with equities moving higher despite a lack of foreign participation, and Treasury yields moving to their lowest levels in over 40 years.

RECOVERY'S SEEDS. The dollar's slide began to gather steam after the Fed's May 6 statement signaling its concern about the minor possibility of deflation. When the European Central Bank indicated a couple of days later that it not only didn't view deflation as a threat but that rates were fine where they were, the euro's gains vs. the greenback got another green light.

In the long run, the Fed could well be sowing the seeds of a more fertile recovery for the U.S., while ECB officials have their heads stuck in the sand. The Fed has cut rates aggressively against the backdrop of a sliding dollar, and along with moves to enact tax-cut legislation, all this should stimulate growth. Just when it was beginning to appear that the Fed had little power left to influence recovery, Alan Greenspan's willingness to publicly raise the specter of deflation may prove to be a masterstroke, sending yields lower across the curve while fueling an extension of stock-market gains.

Compare the Fed's boldness to the ECB's inertia, which has been slow to react to obvious signs of economic weakness -- and stubbornly resists further interest rate cuts. The fiscal focus in Europe has been on its member states keeping to strict deficit and growth targets. Meanwhile, the euro's surge vs. the dollar has erased the stimulus of relatively sparse ECB rate cuts, while structural reforms languish.

NOT SO BENIGN? Still, the benefits of the weaker dollar will be realized only if the U.S. recovery accelerates to full speed -- and that rebound ultimately reverse the greenback's weakness. Continued global economic uncertainties are keeping foreign appetites for U.S. assets at a low ebb, while the combined current-account and fiscal deficits increase the need for investment inflows to stop the dollar falling.

With Treasury yields at their lowest in over four decades and no end to dollar weakness in sight, foreign investors may balk at funding a new and rapidly growing U.S. deficit. If that happens, Treasury yields could move back up, denting stocks and prompting a fresh wave of dollar selling in the process. And then, the greenbacks' weakness may not be so benign. London-based Rugg is a managing currency analyst for MMS International

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