Fed dollar concern shows how tight fix is: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

EDINBURGH (Reuters) - Federal Reserve Chairman Ben Bernanke's new found strong dollar policy is in part a reflection of weakness, caught as he is between inflation and a still fragile economy and banking system.

Bernanke on Tuesday deviated from the usual policy of leaving jawboning the dollar to the Treasury department, warning on the unwelcome inflationary effect of its continued fall.

"We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Bernanke said, nodding as well to its impact on the price of oil and other commodities.

Given the situation -- the economy, particularly the banking system, is too weak to withstand higher rates but yet inflation is rising and risks becoming entrenched -- talking the dollar up and hopefully helping to moderate the price of energy is a sensible and low cost strategy.

The problem of course is that Bernanke can't do much about demand from China and elsewhere for energy and other commodities and having drawn a line in the sand it is always possible, some might say inevitable, that he is asked to defend it.

"Bernanke is signaling that he has reached the limits of how much dollar and commodity-driven inflation he can tolerate," said John Kemp, an economist at Sempra Metals in London.

"He is saying: If there is renewed slide in the dollar, if there is a renewed escalation in the oil price we will have no choice but to respond, no matter how painful that is."

It is the Treasury which has responsibility for the dollar and would make the call for intervention in currency markets to support it, if such a call came, but it is probably fair to presume that the Fed and Treasury are singing from the same song sheet, especially given recent stronger comments from Treasury Secretary Henry Paulson.

It's worth noting too that a study published last week by the Federal Reserve Bank of Dallas laid at least part of the blame for the rising price of oil on a weak dollar.

The paper, Crude Awakening: Behind the Surge in Oil Prices, by economists Stephen P. A. Brown, Raghav Virmani and Richard Alm found that about a third of oil's $60 per barrel rise between 2003 and 2007 could be laid at the feet of the falling dollar. Of course, there is that pesky other two-thirds of appreciation and as it is being driven by rising living standards in China and elsewhere it is largely outside the Fed's influence.

INFLATION EXPECTATIONS HARDEN

There is no question that the recent run of data from the U.S. has shown a disturbing trend, especially in inflation expectations.

The Reuters/University of Michigan Survey of Consumers final reading for May showed one-year inflation expectations surging to 5.2 percent -- the highest since February 1982 -- from 4.8 percent in April.

And as for the Fed's mantra that inflation will fade over time, the public isn't buying it: five-year inflation expectations jumped to 3.4 percent, the highest since April 1995.

"When inflation expectations show a significant rise -- as they have of late -- the standard central bank playbook prescribed tougher anti-inflation rhetoric," Morgan Stanley economist Dave Greenlaw wrote in a note to clients.

"However the economy is quite fragile at present and markets are jittery. Moreover, it's not clear that the threat of a tighter monetary policy would have much impact on households' inflation expectations in the current environment."

If the dollar did make another run lower, it's fair to expect more verbal intervention from the U.S. authorities rather than any quick move to actually buy dollars.

And of course there is also the possibility that something out of Mr. Bernanke's control goes his way for once.

Having peaked above $135 per barrel, U.S. crude fell on Wednesday to below $124 amid growing signs of at least the possibility of a fall in demand.

Americans drove 11 billion miles less in March 2008 than a year earlier, the first time estimated travel on public roads fell in March since 1979 and the sharpest year-on-year drop in the 66 years records have been kept.

Perhaps as significantly, India, which subsidizes fuel prices, hiked petrol and diesel prices by about ten percent, while Malaysia has junked all fuel subsidies, both moves that theoretically should help to curb demand for oil and could point the way to a trend in Asia.

But it's important to remember that any U.S. desire to see a stable dollar is still vulnerable to cracks in the banking and financial system.

The renewed focus on the health and prospects of Lehman Brothers LEH.N, which has seen its shares tumble in recent days, is a case in point.

If we see another Bear Stearns-style run on an investment bank you can expect the Fed and Treasury's commitment to a strong and stable dollar to be tested, sorely.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: saft@thomsonreuters.com--

(Editing by Keith Weir)