Worries Mount but a Dollar Rout Seems Unlikely

When the Bush administration reiterates its belief in a strong dollar, it is now greeted with derisive laughter of the sort that Gordon Brown faced when announcing that his slump in the polls had nothing to do with cancelling his plans for a general election. The White House position is best summarised as favouring a dollar as strong as market forces permit. And that is very weak indeed. Almost every dollar indicator points downward.

Let’s start with the Federal Reserve Board’s monetary policy committee. Chairman Ben Bernanke and his colleagues are under pressure to continue lowering interest rates. For one thing, the economy is slowing, and Bernanke has to worry that the deteriorating housing market will turn a slowdown into a recession. The rates on some 2m sub-prime mortgages are due to jump next year from the 7%-8% range to 9.5%-11%, raising the monthly payment of the typical sub-prime borrower by about $350 (£170). Many won’t have the money, and others will have to cut back on purchases of consumer goods, especially if petrol stays around $3 per gallon (39p per litre).

Even homeowners with fixed-rate mortgages are expected to find high (by American standards) petrol prices crimping their budgets. And they won’t be able to count on borrowing against rising equity in their homes, because the days of ever-ris-ing house prices are over. Add a softening of the jobs market, and you have a prescription for a slowdown, in the view of most economists, or even worse, a recession, predicted by one-third of economists surveyed by The Wall Street Journal.

The Fed also has to worry about the continuing problems of the financial markets. As banks write off billions of dollars, with unknown billions more to come, their willingness and ability to lend even to credit-worthy businesses and individuals shrinks. That will add to the drag on the economy, and increase the pressure on the Fed to cut interest rates.

This lowers the return foreigners can expect on dollar investments, especially if the rate cuts are accompanied by a slowdown. And even though America’s trade deficit is narrowing, it remains large, pumping more dollars onto world markets. Add lower returns on investments to large losses from the fall in the greenback, and large dollar holders, notably China and some Middle East countries, are beginning to talk about selling part of their dollar piles.

Not all of this is bad news for the American economy. The falling dollar has stimulated exports sufficiently to offset some of the downward pull of the housing market. With the dollar headed towards $2.10 to the pound, and closing on $1.50 to the euro, Americans are staying at home, Europeans are flooding into American cities to do their Christmas shopping, and buyers of business equipment are finding that American suppliers can offer more favourable prices than their German and French rivals. Which is why Nikolas Sarkozy warned America that an economic war might break out, although just how he would wage it is unclear – unless he tips the EU into protectionism.

That, of course, is no longer out of the question. With the Chinese currency more or less pegged to the dollar, Chinese exports are not disadvantaged by the dollar’s weakness. That puts the brunt of the adjustment to America’s weakening currency onto Europe, as the strong euro sucks in imports and makes exports less competitive. So the EU is now threatening to slap tariffs on “subsidised” exports from China.

Protectionist sentiment is also rising in America. Candidates for the Democratic nomination are threatening to eschew new trade deals and even to impose restrictions on imports. Democrats are also threatening retaliatory, offsetting tariffs on Chinese goods if the regime continues to cling to its dollar peg. And both parties are increasingly nervous that the accumulated capital of so-called sovereign wealth funds, many run by hostile governments, will be used to “buy up America”.

Despite all this, a dollar rout remains unlikely. For one thing, it is not certain that America is tipping into recession. We will know more after the Christmas shopping season, which could turn out to be a good one for merchants. Bench-mark retailer Wal-Mart is predicting a “solid” holiday season, and the National Retail Federation is predicting sales will be 4% up on last year.

That won’t elicit wild cheering from shopkeepers, who are already cutting prices, but it would hardly be a calamity for the economy.

More important, there are signs that the housing market’s problems have finally caught the attention of the Bush administration. Some officials are proposing a moratorium on interest rate resets until a case-by-case review enables lenders to identify borrowers who, with a little bit of flexibility on the part of lenders, can avoid foreclosure. Others want to extend the activities of government agencies involved in the housing market. Cataclysm might not, after all, be around the corner.

And the Fed just might not capitulate to the panic being promoted by the chief executives of investment banks, eager to avoid following Stan O’Neal and Chuck Prince into involuntary retirement. Instead, it might notice that Blackstone and other investors have begun to shop for undervalued sub-prime investments, signalling that the worst might be over. An end to rate cuts in America would moderate the pace of the dollar’s decline, especially if the Bank of England and the European Central Bank start lowering their rates.

Throw in slowdowns in Britain and euroland, which should weaken the pound and the euro, and the bears might have to settle for a continued but gradual decline in the dollar rather than a rout.