Important change at the Fed

Additional uncertainty over Fed policy is likely to be created early in 2006 when Chairman Alan Greenspan’s term in office comes to an end after 18 years. Ben Bernanke, head of the Council of Economic Advisors, has been nominated to succeed Greenspan and has pledged policy continuity. (see “Bernanke tabbed as new Fed head”). The new chairman is likely to be slightly more cautious in the short term, especially given his previous unease over deflationary trends in the economy, which could deter further rate increases. It is possible the rate-hike cycle will peak at the end of 2005, making the dollar vulnerable going forward.

Interest rate levels will still offer some support even if the Fed halts the tightening process. With U.S. rates at 1 percent, the dollar was vulnerable to selling pressure during 2003 and 2004 — there was a strong incentive for investors to use the dollar as a global “funding currency” and invest in high-yield securities. Higher U.S. interest rates have discouraged dollar selling, and there has been a greater temptation to use currencies such as the Euro and yen as funding vehicles. Given the rise in short term yields, the dollar will, therefore, be less vulnerable to selling pressure, but it will still be vital to sustain confidence in the U.S. economy.