Currency Crisis in the Dollar May Be the Next Shock - BMO Nesbitt Burns

The Bottom Line: The Latest View on the Economy
Next Shock: Currency Crisis?
by Sherry Cooper
July 7, 2008
BMO Financial Group

The malaise of the U.S. economy is palpable. Not only have sky-high food and gas prices drained consumer discretionary income, but the weak dollar has dampened travel plans and the stock market declines have exacerbated the wealth destruction coming from the housing collapse. Businesses in many sectors continue to lay off workers as earnings collapse in the auto and airline industries, banks and brokerages, housing-related retail stores or just about anything discretionary.

Consumer finances are in perilous condition, a harbinger for further declines in consumer confidence. With growth running at about a 1% annual rate in the second quarter, most of which is in net exports, the Fed would have trouble doing anything but remaining on the sidelines, despite the mounting inflation pressure.

The ECB hiked rates last week for the first time in just over a year in a pre-emptive strike against inflation. The move had been so well telegraphed that the U.S. dollar actually rallied on the news, especially after Trichet indicated he had no bias on further moves.

A recession in the U.S. is apparent, but other G7 countries are now more vulnerable than ever to a punishing slowdown as well. After a decade and a half of continuous growth in Canada and Britain, a downturn comes as a painful shock. Ontario’s economic decline portends the spreading pain. Britain appears to be following the U.S. in a downturn in housing and retailing. As in the U.S., the bad news has weakened the prospects for the incumbent political parties.

Though many are calling for the government in both Britain and the U.S. to do something to spur the economy, the rising inflation pressure ties the hands of the central banks. Moreover, the governments cannot afford more crowd-pleasing giveaways, and there is a question just how effective the U.S. tax rebates were in the first place.

In the meantime, for decades, many emerging countries have fixed their currencies against the dollar to protect economies that were small, undiversified and dependent on the United States. But they are now the engines of global growth as the G7 struggles.

The BoE and the Fed have commented that inappropriately low interest rates in countries that peg their currencies to the dollar were helping to fuel commodity price inflation. Many of the countries in the Middle East and Asia are running double-digit or record-high inflation; but central banks cannot raise interest rates in response as long as they choose dollar pegs to keep their currencies undervalued.

The sustainability of the dollar pegs hinges on the U.S. interest rate outlook. If the Fed refrains from raising rates because of economic weakness, despite the rise in inflation, pegs will come under significant further pressure. This is a pressure cooker running over the boiling point.

The Bottom Line: The world may realize that it is no longer reasonable for the dollar to be the anchor currency. If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy.

Dr. Sherry Cooper is the Executive Vice-President, Global Economic Strategist, BMO Financial Group, and Chief Economist, BMO Capital Markets & BMO Nesbitt Burns