The fall in the Mexican currency wiped out early gains that were fueled by the expectation that the Mexican central bank will maintain its benchmark interest rate at 7.5% tomorrow.

Investors expect the Peso to bounce back due to the widening gap in the difference between the U.S. and Mexican interest rates, with Mexican assets looking increasingly attractive.

Bernanke explained that credit becoming more expensive and less available was causing economic growth to be restrained. He went on to state that the downside risks to growth have increased and the outlook for the economy has worsened in recent months.

It is anticipated that Banco de Mexico will begin to cut rates soon, possibly as early as next month, in an attempt to boost economic growth.

“He reintroduced testosterone to the inflation-fighting resolve of the Fed,” said Diane Swonk, chief economist of Mesirow Financial Inc., an investment management firm. “This is a pure male thing. He said to the markets, ‘You think I’m a wimp? Take me on.’ ”

Gone, during Bernanke’s remarks to a bankers’ conference, was any mention of a Fed pause in its two-year series of interest rate increases. Gone was any fretting over the danger of pushing interest rates too far and triggering a slump. Instead, he declared that the recent rise in inflation would not be tolerated.

Bernanke, who took over as Fed chief in February, needed to send such a signal to counter the markets’ doubts about his anti-inflation resolve, analysts said — even though it meant jolting the markets with the implication of higher interest rates. He called recent inflation trends “unwelcome,” noting that the Labor Department’s consumer price index, excluding volatile food and energy items, had risen at a 3.2 percent annual rate over the three months ended in April and at a 2.8 percent pace in the six months ended in April.

When Bernanke told Congress in April that the Fed might pause in its rate increases, “he sent a bad message that the central bank was going to be soft on inflation, and that was the wrong message to send when energy, commodities and raw materials prices were at multi-decade or historic highs,” said Richard Yamarone, director of research at Argus Research Corp. “I was pleasantly surprised [Monday]; my beliefs were confirmed that the world’s most important central banker was in fact vigilant against inflation. He finally laid that out. I’m surprised he didn’t do this earlier.”

Bernanke’s remarks followed extensive discussion within the central bank about its strategy for communicating with the public. Bernanke has long argued that Fed officials should be more open about their thinking to help the markets anticipate the likely course of interest rates. But that effort may have backfired: Recent attempts to reflect the Fed’s internal uncertainty and debate caused some investors to question whether the central bank’s commitment to low inflation had weakened with the retirement of former chairman Alan Greenspan.

Most of the Fed’s top policymakers believed they were nearly done when they raised their benchmark short-term interest rate to 4.75 percent at their meeting in late March, Bernanke’s first as chairman, minutes of that session show. And some of them worried then about the danger of raising the rate too high and causing an economic downturn. But others expressed concern about the inflation risks posed by rising prices for energy and raw materials, tightening labor markets, and robust economic growth — suggesting that more interest rate increases might be needed.

Fed officials again lifted the rate in May, to 5 percent, and left the door open to more increases. But several also spoke more openly in public about the difficulty of knowing when to stop raising interest rates — the classic dilemma for any central bank and one that the Greenspan Fed faced three times in his 18-year tenure.

The problem is that Fed interest rate changes take effect over many months and even years, as consumers take on new mortgages, car loans and credit card debt and as businesses borrow to expand. Higher interest rates eventually crimp spending, causing the economy to soften and inflation to fall — but the process takes time.

And, as Bernanke observed in a paper he co-authored in 1995, when interest rates go up, economic growth typically slows many months before inflation falls .
This makes it particularly tricky to decide when to stop. The Fed today is close to reaching that “no-man’s land of not knowing if you’ve gone too far because of the lags,” Swonk of Mesirow Financial said.

Inflation rose or stayed high for some months after each time the Greenspan Fed finished a series of interest rate increases, in 1989, 1995 and 2000. Twice, in 1990 and in 2001, the Fed tightenings were followed by recession. Only in 1995 did the Fed achieve the central banker’s Holy Grail of a “soft landing,” in which an overheating economy cools to a healthy pace of expansion without a painful slump.

Greenspan faced higher inflation than Bernanke faces, and he raised the federal funds rate much higher than it is now before stopping: to nearly 10 percent in 1989, to 6 percent in 1995 and to 6.5 percent in 2000.

The Fed has been steadily raising its benchmark federal funds rate, the overnight interest rate on loans between banks, for two years, from a very low 1 percent in June 2004. With rates so low for so long, the housing market boomed through last year and began to soften only in recent months. Consumer spending remained strong through earlier this year and has just recently started to sag.

Bernanke said Monday that the expected economic slowdown “seems now to be underway,” but he expressed more concern about inflation and signaled strongly that interest rates will move higher before he is done.

Financial markets, which have been volatile for weeks because of inflation fears and uncertainty over the Fed’s likely action, sold off Monday and yesterday on expectations of more rate increases.

“This happens all the time at the end of a tightening cycle, and everybody is all atwitter because they don’t know when it will end,” said Mark Gertler, the New York University professor who co-authored the 1995 paper on Fed policy with Bernanke. “Our paper tells you there are lags in the effects of policy but doesn’t tell you when to stop.”

SOURCE: Washington Post

The possibility that the Fed will raise rates for the 17th straight time to 5.25 percent sparked a round of dollar short covering, helping the U.S. currency recover from a sell-off on a soft employment report late last week.

But gains were limited as some investors worried that Bernanke’s comments did not necessarily guarantee that a rate rise is in the bag this month.

“The market is more or less split between whether the Fed will raise or not, so it’s hard to take on risk either way at this point,” said Fumihiko Kawano, forex manager at Nomura Securities.
Fed funds futures indicate a roughly 70 percent chance of a rate hike at the Fed’s two-day policy meeting that starts on June 28, up from less than 50 percent on Friday.

Traders said any recovery was likely limited with the renewed focus on a weaker dollar helping rein in the massive U.S. trade deficit and playing a role in correcting global imbalances.
“Bernanke’s comments may have triggered some short covering … but a rise in the dollar/yen to 113 yen is going to be pretty tricky,” said Nobuaki Kubo, forex planning manager at Resona Bank.

So far this year the dollar has tumbled 8 percent against the euro and 5 percent versus the yen, with the slide accelerating after the Group of Seven industrial powers called in April for China and other trade surplus countries to allow more currency strength.

RATES AND DEFICITS
Even if the Fed raises rates later this month, it would likely be the last before the central bank takes a break from the two-year run of credit tightening, just as other major central banks look set to bump up rates.

Dealers said that the dollar could face more downward pressure if the European Central Bank hikes rates at its policy meeting on Thursday, with speculation still simmering of a potential half-percentage point increase.

Most analysts expect the ECB to lift rates by 25 basis points to 2.75 percent and to signal more credit tightening is likely in store.

Global imbalances are also expected to be a focus later in the week with the release of U.S. trade figures on Friday, just as the Group of Eight finance ministers meet in St. Petersburg.
Japanese Finance Minister Sadakazu Tanigaki said the impact of high energy prices on the global economy would be a topic at the G8 meeting.

SOURCE: Reuters

JON’S COMMENT
How much further will the US extend its gain this week and could this be a good time to short the Dollar before the European Central Bank officially announce its rates hike? Even with a rate hike for the US Dollar later this month, with a likely pause afterward and some weak data, I believe the US Dollar will go back to it’s recent lows in the coming months.

Forex traders will admittedly be watching economic indicators closely for insight into the Fed’s likely course of action. This includes data on the housing market, for the Fed could conceivably continue to raise rates as long as the housing market remains overly buoyant.

Goldseek reports:

The economy grew 4.8% in the first quarter of this year. Inflation is at the upper end of the Fed’s comfort level. If we see another two months of that type of environment, it is likely they will raise rates yet again…

In this vein, Ben Bernanke’s hint that the Fed might end its cycle earlier than expected probably hastened the dollar’s decline.In this vein, Ben Bernanke’s hint that the Fed might end its cycle earlier than expected probably hastened the dollar’s decline.