Fed Vice Donald Kohn Urges Emerging Markets to Drop the Dollar Peg

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Fed Vice Chairman Donald Kohn said the world would be a lot better if emerging markets simply dropped their dollar pegs. This means they would stop importing U.S. inflation by matching the Fed rate cut for rate cut.

In a speech earlier this week Kohn said, “In those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.”

As Aussies know from yesterday’s credit figures, you can reduce aggregate demand in an economy by raising interest rates. But you can’t reduce demand in your own economy if your interest rates and your currency are pegged to the value of the U.S. dollar. This is the dilemma much of the developing world finds itself in.

They are simply going to have to let the U.S. dollar go. The Fed makes rate policy suitable for the American economy. The American economy is bloated with debt and on the verge of a recession. The Fed reckons slow growth is a bigger threat to the U.S. economy than inflation, so it’s leaving rates low.

Sometimes it’s hard to say goodbye. It’s been a decent macroeconomic policy to make things, peg your currency to the greenback, and sell to the American consumer for the last 50 years. He had cash. He had credit. And his appetite for stuff seemed nearly inexhaustible.

But human beings have the same appetites…for calories…for cars…for the good life. And there are a lot of human beings chasing better standards of living. There is plenty of demand in the global pipeline. Anticipating this, the world economy needs to rid itself of its America addiction. But it’s going to have go cold turkey.

The transition toward more domestic consumption in developing economies isn’t going to be seamless or smooth. It’s going to be bumpy. There will be pushing and shoving. For investors, there might not be too many places to keep your money safe. If paper currencies are relatively unsafe, tangible assets may be relatively safer.

The trouble for investors is that rising commodity prices don’t necessarily equal rising share prices for commodity producers. You have to be selective.

We reckon commodities themselves are probably due for a bit of a breather in the second half of the year. The ongoing solvency crisis in the financial sector is going to be a major drag on the share markets. But in the meantime, the long-term trends should favour Aussie resource investors.

Besides, everyone is so gloomy those days. We should know. It takes a gloomster to know a gloomster. We see a lot of gloomsters around. That worries us. Are we missing something?

If everyone is convinced nothing is worth buying and nothing will go up, what does that tell you? Has sentiment gotten as bad as it will get? If the stock market leads the economy, could we see a turnaround in the second half of this year, forecasting the bottom of the credit crisis and U.S. housing prices in the first quarter of next year? More on that tomorrow.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Unlikely people who come by the office now “happen to mention” that the US is going into recession. This tells me that a downwards OVER CORRECTION is now imminent.

    Productive enterprise is still evident wherever you look – so the end is not neigh – even if you Comsec balance and super balances take a medium to long term hit. So what!

    I agree with Dan’s view that the longer term outlooks for energy and resources are good but my punt would be that a significant correction is now very close at hand. The relationship between supply , demand and price is not linear – meaning that a hypothetical drop in demand can result in a higher or lower (by percentage) adjustment in price. And, if demand by Australia for petroleum imports can drop by 18% really quickly (as a consequence of the price rises) the same will happen everywhere else. As the cost of cars (and the cost of running them) goes up the immediate impact will be reduced demand for steel and iron ore (I expect an initial over correction here as well). There are of course deeds and lags to consider and we are now at the top of a steep pricing pyramid. Next year’s iron ore price won’t collapse but it could well be a 40% drop on this year’s price. The same goes for many other commodities.

    In current circumstances I don’t know why any country would want to told onto a dollar peg or even a peg to a basket of currencies. Climbing off a peg is risky, difficult and in some cases slowed by a need to retain social cohesion. But climb off they will!

    Coffee Addict
    July 2, 2008
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  2. Dan, you have connections … so what are the volume terms on the Rio contracts? Can Baosteel switch to the spot market?

    I need to sift the depegging through the greymatter (you might say dishwater). I keep asking myself about what the realpolitik affect on that USD will be.

    We are talking about an attempt to deflate those de-pegged export prices aren’t we? Why should the former pegged country merchandise sellers or commodity exporters keep pricing in USD as they are being hit with inflated labour costs and raw materials de-coupled to the currency they are buying in? It’s not like the pegged countries printed those USD’s is it? And how are they taken out of circulation, the more I think about it the more I think it is a hedge funds dream, is this some scheme dreamed up by Rubens mates as the new big thing? Can we revisit Mahatir’s capital control regime to brush up?

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  3. I meant on producer raw materials that even though they are priced in USD that they are inflating on market price as if they were decoupled to the USD.

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  4. “Correction Theories” always amuse me.

    For any market, the correct price always is the actual price in any moment.

    Money is a commodity. Folks swap money for other commodities — stuff of the earth — and capital — Future Money. This swap reflects the call for one and the offer of the other.

    Calculating this swap ratio yields a value. We call this value a price.

    For the price of any commodity or capital to rise, more money (notes and coins) must offered and spent to buy it than less money offered.

    This money must come from somewhere — peeled away from other bets.

    When a man believes the price of a thing will rise quicker than the prices of all other things and that man puts money up to support his belief, he makes a bet about the future state of the world.

    Once made and distributed, Money in Circulation (notes, coins) never gets destroyed.

    Thus, if the price for a trading good falls, fewer folks have bet on such a good. Those who sold their controlling interest believe better bets exist elsewhere.

    Prices fall in tandem for commodities when new Commerical Credit seems worthy to bet upon. When bets on new Commerical Credit rise faster than bets on Commodities, economic expansion happens.

    Smack MacDougal
    July 3, 2008
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  5. Everyone is gloomy these days…I’m not so sure Dan. I spoke with 2 collegues seperately the other day and was blown away with how gloomy the aren’t, and the financial positions they have themselves in as a result.

    Both flight attendants(theres where the gloom should start) the first has bought an apartment in Redcliffe, Brisbane about 18 months ago. Repayments were initially $1600 per month, now she’s paying $2220. She takes home $3200-$3600 a month at the moment, and as she is casual(!) she had noticed the hours falling off at the same time as repayments creep up. She told me she hasn’t been grocery shopping for 6 weeks, and gets by on tinned food and the odd loaf of bread from the local shop, as well as eating as much food onboard the aircraft, supplied by the airline, as possible when at work. Unbeleivably, she tells me she’s NOT IN TROUBLE YET, and when her tax return comes through, and she gets a bonus(she is relying on) she can stop living off her credit card, and then sort things out! How optimistic can she be?

    The second flight attendant lives in Sydney, and when we were talking about the stock market, mentioned that he hasn’t had one yet BUT if he gets a margin call, he’ll have to sell his house. He said this without the slightest hint of doom or gloom. I asked if he caould tell me how much the margin loan was…answer $300,000!!!

    As the Mogambo Guru might say “We’re – or in this case – They are freakin doomed!”

    Cheers, Luke

    Luke Clements
    July 3, 2008
    Reply
  6. Mortgage woes displace you from your home.
    Fuel calamities strand your SUV.
    Your girlfriend leaves you for someone who can afford gas heating.
    Dog food starts to look ever more appetizing.

    Jack Nicholson sang in ‘As Good As It Gets’, “always look at the bright side of your life…”

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