Dollar Rebound in 2008: A Fairy Tale?

03/28/2008 02:48 am ET | Updated May 25, 2011

Several analysts expect the U.S. dollar to rebound in the second half of the year. A slowing U.S. economy always affects the rest of the world with a delay, they say, and most of the bad news may already be priced into the greenback. "For Euroland, historically, the delay has been one or two quarters," notes Stephen Roach at Morgan Stanley. Analysts like Mr. Roach argue that central banks that proactively cut rates to bolster growth (like the Fed) will now see their currencies rally, and central banks that don't cut rates will see their currencies weaken. The implication here is that investors will move money away from yield and turn their focus to areas of growth. Going by this logic, the U.S. dollar should benefit from the Fed's amplified focus on growth.

But what happens when the Fed's monetary policy fails to work? "Since the start of the global financial crisis last August, monetary policy has been remarkably ineffective," writes Wolfgang Münchau at the Financial Times. "We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run." He adds: "Among the various channels through which monetary policy affects the real economy, the credit channel is one of the most important. If real-world interest rates are determined independent of a central bank's monetary policy, the effect of monetary policy on economic growth is correspondingly reduced."

The key question that needs to be raised by those expecting a dollar rebound later this year: Are traditional assumptions about the connection between growth and proactive interest rate cuts still valid if monetary policy fails?

More commentary from Mr. Münchau: "This credit crisis is first and foremost a financial solvency crisis. When you are insolvent, the rate of interest is irrelevant because no one will lend you money in any case. And if someone did, the interest rate would still be irrelevant, since you are not going to pay them back. If you face only a liquidity problem, the rate of interest matters a great deal, since it determines the price you pay to regain liquidity. This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with sub-prime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market."

Another big question to ask, and the point I am trying to make here: What happens if the solvency crisis dissipates over the next few months? In that event, interest rate cuts from other central banks will have a bigger impact on growth than the present day "proactive" (read: impotent) Fed rate cuts. There is also a real risk that the Fed will have run out of ammunition by the time the solvency crisis has run its course. Interest rates can't go below zero, and if the federal funds are lowered beyond a certain point, the ability of the Fed to stimulate the economy comes to an end.

Will investors buy currencies associated with monetary policy that has the desired growth effects? In that case, the growth story might still dominate the currency markets, but the greenback won't be the winner.