View from City Road: Rising inflation rules the dollar

The dollar has gained nothing from the Federal Reserve Board's latest interest rate hike.

For a brief moment after Tuesday night's half-point rise in the key Federal Funds rate the US currency rallied above DM1.67 and Y104. But it has sagged ever since.

Superficially this might seem surprising. US rates have been rising as German rates have eased, moving two percentage points in the dollar's favour since the start of the year.

The answer lies in expectations on inflation.

Next year the US inflation rate - presently 2.4 per cent - is expected to be a point or more higher. But German inflation is forecast to slip from 3.2 per cent to below 2 per cent. Real interest rates - after taking inflation expectations into account - are therefore moving against the dollar.

The dollar is also being undermined by the growing US current account deficit, which could hit dollars 150bn this year, despite the narrower shortfall for March reported yesterday.

Add to that a permanent annual capital outflow of dollars 50bn to dollars 60bn as American capital floods into foreign stock markets and America's overall balance of payments deficit looks as bad as it was in 1987, the last dollar crisis.

Another reason the dollar fell after this week's rate hike was the perception that monetary tightening had come to an end for the time being, an impression confirmed yesterday by Lloyd Bentsen.

That's it for now, he seemed to be saying, though he may yet have to eat his words.

Intervention will help to ease the dollar's plight - central banks were reported to be checking exchange rates yesterday - but the effectiveness of that tool diminishes each time it is used.

Once it stops working altogether, the only remaining option will be for the Fed to raise rates yet again, sacrificing economic growth for a stable dollar.

The Clinton administration would fight this tooth and nail, preferring to let the dollar sink to surrendering the present economic expansion, however. Let battle commence.