The surge in demand for dollars this week, which has pushed the federal funds rate to 10 1/2% today, may indeed be nothing more than year-end seasonal demands at work, as the financial press has been explaining. If so, fed funds would slide back below 9% as the new year begins without any help from the Federal Reserve. But the Fed certainly seemed surprised by the surge, intervening aggressively to add reserves to accommodate demand, and still fed funds moved beyond the target range. The price of gold coincidentally fell $10 an ounce, to $408, and the yen/dollar rate moved above 125. Exactly a year ago, with the same "seasonal demands" presumably at work, fed funds was steady at 6 3/4%, central banks were intervening to prop up the dollar, which hit a record postwar low of 122.85 yen, and gold was at $482, down $5 in the last two trading days.
This leads to a conjecture that something else is going on here, perhaps the shift in global expectations about the course of the dollar that we have been waiting for. The central banks of our major trading partners have once again demonstrated the capacity to defeat the dollar bears and keep it above 120 yen. The myth that the central banks can't withstand speculation against the dollar because they don't have enough of them had become an article of faith among dollar traders. It had been cemented into place in 1987 as attempts to defend the dollar failed, but only because the Fed itself was sterilizing the interventions. This year, the Fed has been pushing up the fed funds target, the correct companion to the interventions, and the dollar/yen rate remains roughly the same while 15% has been knocked off the gold price.
Global expectations about the dollar's future would have been healthier in the last two months if Martin Feldstein had not shot off his mouth, or if Treasury had been forceful in denouncing his views. But assurances from the Bush team since then, plus the Fed's willingness to tighten short rates another notch, may finally have persuaded enough dollar bears to become bulls. The action in gold and fed funds this week is at least in accord with this possibility. This would mean the Fed would have to make more aggressive additions to reserves to keep the price of gold above $400 and the dollar from climbing above 130 yen. We could also imagine the Fed soon having to debate whether or not to ease on short rates, getting the yield curve back where it belongs. Something has to give. The dollar/yen rate can't go on for another year at the same level and spreads remain as wide as they are in the interest rate schedules of the two countries. The shift in dollar expectations, if it has arrived, would then set off a rally in stocks and bonds in the weeks ahead (as long as the steroid beef trade skirmishing can be contained).
Happy New Year!