Dollar intervention and cross purposes

``At the end of the day, the financial sector is our flagship,'' Kenneth Rogoff, a professor of economics at Harvard University, and a former chief economist at the International Monetary Fund, said in an interview on Bloomberg Radio Sept. 19.
``It has been crushed, and that's going to have a big impact on international capital flows. That's going to affect the positions of the dollar in the global financial system.''

The capital flow impact is going to be significant but that is based on the idea that the problem is localized to the US. The US is the epicenter for the crisis, but we are seeing that the bank problems also include Europe. Fortis is being bailed-out to the tune of $16 billion, Bradford and Bingley, the British lender, was seized by the government and a Hypo Real Estate Holding loan is being guaranteed by Germany. Currency trading is based on relative prices and if the European market gets the same sickness as the US, the currency price may not change. The dollar is up on the bail-out announcement. If the perception is that the US is ahead of the curve in solving the problem, then a flight to quality to the dollar may occur. This is a rosy forecast which seems unlikely given the ambiguous nature of the TARP plan.

Intervention will not be necessary because joint banking problems will not radically change the capital flows. Note that it will change capital flows for other countries which have been less affected by the crisis. Nevertheless, we would argue that given the large financing needs maintaining existing capital flows into the US may not be enough.

A dollar decline is more likely because of the massive extension of swap lines to other central banks from the Fed which is flooding the market with liquidity. It is this dollar liquidity which could send the currency lower. So, in fact, there is dollar intervention through the swap lines. A currency problem exists if there is a dollar decline in response to the flood of liquidity which will then have to be offset by dollar purchases in the currency market, a form of sterilization. This type of intervention will not change the underlying dynamics of the currency market but will send a warning to traders to slow their dollar sell-off. Sterilized intervention without a change in underlying policy or economics will not be effective.

Intervention can only be analyzed in the context of what will be the credit extension of the Fed to other central banks because this is the action which will really drive dollar behavior. Intervention discussion because of high volatility are misplaced. The high volatility in the markets is a result of the high market uncertainty and should be expected. If you want dollar volatility to decline, provide clarity on what policies will be implemented during this crisis.