The Day The Dollar Died

The Fed may have missed its last chance to put the inflation genie back in the bottle...

I'M CALLING it the "Pesofication" of the US Dollar.

But we're really talking here about the Dollar's long-term demise, writes Martin Hutchinson, contributing editor to Money Morning.

The Pesofication of the Dollar represents the end of the greenback as a major world currency and figures to be one of the major long-term challenges that US investors will face.

The Dollar's demise was set in motion several years ago. But the greenback's fate was sealed in late April, when US Federal Reserve policymakers had a final chance to take a stand against inflation – and failed to do so.

Let me explain ...

Four years ago, I referred to the US greenback as the "Bernanke Peso." I coined this term, reasoning that US Federal Reserve Chairman Ben S. Bernanke's decision to cut interest rates even as inflation was accelerating was bound to cause the Dollar to lose value at an ever-increasing rate. 

My prediction held up for a time, but was then derailed by the little matter of the collapse of the US banking system. However, after the Fed's April 27 meeting, I can report that we're right back on track, and the Pesofication of the Dollar is progressing with startling rapidity.

That late-April meeting of the central bank's policymaking Federal Open Market Committee (FOMC) was the Fed's best chance to set a new course before its $600 billion "quantitative easing" program is scheduled to end on June 30. (The FOMC meeting scheduled for June 20-21 falls too close to the end of the Fed's quantitative-easing/US Treasury-bond-purchase program for a new policy to be established.)

Bernanke seemed to underscore this by announcing that the central bank would, indeed, stop purchasing Treasury bonds on that date. He also explained that, in his view, the "market effect" of bond purchases is determined by the "stock" of bonds outstanding – as opposed to the "flow" of bonds into and out of the market. 

We shall see. 

Here's my bet: When the Fed stops buying about $225 billion of the Treasury's $400 billion quarterly funding needs, all hell will break loose in the Treasury bond market. After all, the two largest T-bond buyers are not going to be particularly active this summer: The Bank of Japan (BOJ) will be too busy spending money on that country's reconstruction from the earthquake/tsunami/nuclear power plant accident to be buying much US government debt, while its counterpart in Mainland China – the People's Bank of China – has made it clear that it regards the United States as a pretty dodgy credit risk.

On the interest-rate side, Bernanke left the Fed's "extended period" language for holding rates in place at their current level. During his late-April press conference, he explained that "extended period" meant at least two FOMC policy meetings. So if the Fed removed the language in June, it could raise rates in September.

However, the bottom line is this: Interest rates are not going up at least before the end of the summer. And if they do go up at that time, it will likely only be a miniscule increase.

When it comes to our currency, inflation is public enemy No. 1. And yet, Fed chairman Bernanke remains completely unfazed by the evidence of rising inflation. He takes credit for the rise in stock prices since he began his "QE2" policy last November. But the Fed chief refuses to admit that the prices of gold, oil and other commodities that have really escalated in recent years have anything to do with Fed policy. 

Indeed, as far as Bernanke is concerned, the need to pay almost $5 a gallon for gasoline is not his fault and does not indicate any but the most temporary increase in inflation. Even though the Fed has raised its inflation forecast for this year, Bernanke still regards the inflation rate as too low, not too high. 

First-quarter gross-domestic-product (GDP) figures announced the day after the Fed meeting showed that the "PCE deflator" measure of inflation – the one that the Fed monitors – was running at 3.8% in that quarter. Since the Fed forecasters the day before predicted a PCE-deflator inflation rate of 2.1% to 2.8% for the entire year, you can see that we're pretty clearly off track.

One problem is that Bernanke looks at the so-called "core" rate of inflation in personal consumption expenditures, a figure that is reported several months late and does not include anything whose prices are actually rising. When normal observers see inflation taking off pretty rapidly, Bernanke takes false solace from the fact that – according to his preferred measure – all is quiet on the inflation front.

Be warned: There is every chance that the Fed will lose control, inflation will spiral - and not just to the ruinous levels we saw in the 1970s, but well beyond them, too. Even after that occurs, Bernanke will refuse to launch any sort of significant counterattack, or combat it. 

This happened before – back in the 1972-73 time frame – and it took a full decade of punishingly high interest rates and the commitment of a Fed chairman named Paul A. Volcker to solve.

This time around, we may not get so lucky.

Inflation may become much more acute - reaching the excruciating/ruinous 20% to 50% level – rather than reaching and then holding steady at the uncomfortable-but-bearable 10% level.

If we end up with an inflation rate in excess of 20%, the whole game changes. First and foremost, the US Dollar is no longer the Dollar; it is a Peso. And not just any Peso – it is a typical-1980s Latin American Peso, a currency that devalues on a regular, near-continual basis, and is forced to drop three zeros every decade or so.

At that point, the world will no longer accept the US Dollar as a reliable store of value; trade-settlements and other international payments will be diverted into other currencies and even the doziest central bank will stop buying US Treasuries. The Dollar will essentially be dead as a major currency. 

If that happens, when we write the epitaph for this country's currency, April 27 will be remembered as the "day the Dollar died." That was the day that Bernanke and his fellow Fed policymakers failed to capitalize on their final real chance to stuff the inflationary genie back into the bottle – and set the "Pesofication" of the greenback into motion.