“I have always argued very strongly that it is not a good idea to focus on asset prices like the exchange rate over and above the effect it has in terms of things we should care about as central banks," Frederic Mishkin, in response to a question at an economics event in Frankfurt.
Mishkin’s view is consistent with our earlier comments that the Fed is willing to forsake the dollar in order to focus on saving the domestic housing market. The dollar will have to be sacrificed if the Fed believes that a preemptive lowering of rates is the solution to the housing debacle.
However, this does not mean and that the dollar will see a huge plunge in the near-term. Rate cuts are already included in expectations. If the US economy stabilizes, there will be less reason to cut rates. (The fed funds futures will lower their probability of a rate decline.) There will also be less likelihood of a decline in stocks; at least based on time line earnings. (Nevertheless, much of the recent stock gain has been driven by the discount factor.) Financial flows may not be one directional out of the dollar if growth and rates become range-bound. Also, as mentioned before, a slowdown in Europe or the appearance of inflation will make the Euro less attractive.
There will need to be a catalyst for further dollar declines. The catalyst which is most likely is a carryover from the housing market to the rest of the economy. To date, the economic numbers have not shown this carryover even though the conditions are ripe for a further slowdown. If this catalyst appears, the Fed will lower rates which will have the impact of making dollar assets less attractive based on interest differentials.
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