When it comes to talking about the dollar, silence is usually golden at the Federal Reserve. But this week Ben Bernanke waded into waters usually charted by the US Treasury in order to bolster the Fed’s inflation-fighting credentials.

The Fed has a twin mandate of keeping both unemployment and inflation low. By linking higher import prices and consumer price inflation with a weaker dollar, Mr Bernanke highlighted how the central bank is caught between the nasty forces of slow growth and rising consumer prices.

For a brief period, the jawboning of the currency market worked. The dollar rallied as forex traders were chastened by the threat of intervention and oil prices fell.

Then on Thursday the dollar reversed course and the price of crude surged after hawkish inflation talk from the European Central Bank. Unlike the Fed, the ECB just has one mandate: keeping inflation low. And it appears intent on following up talk with deeds.

The biggest credibility test for any central bank is containing inflation. Clearly the Fed and other central banks are worried that the consumer price genie may be out of the bottle.

At the Fed, the stakes are potentially much higher as its aggressive rate cuts this year
have accelerated the long decline of the dollar. This has stoked soaring oil prices and the continued march higher in headline inflation.

On Friday, oil surged more than $11 a barrel after a poor employment report, its largest one-day dollar rise in history. At a record $139 a barrel, and higher by 42 per cent this year, oil is arguably a harbinger of both recession and inflation. The blades of this doubled-edged sword are sharpening anxiety among central bankers, investors and consumers.

Consumers are being pushed to the brink as they endure a collapsing housing market, rising unemployment, higher food and petrol costs, and modest wage growth. This was highlighted by the jump in May unemployment to 5.5 per cent, the largest one-month jump since 1986 as more people search for work.

Elevated oil prices also hurt global growth. Stronger growth outside the US has boosted the appeal of buying dollar-denominated exports in recent months. While the weaker dollar has fanned higher import prices, the boost in exports has helped stem the US economy’s descent into a full-blown recession for now.

So it seems reasonable on the part of the Fed to try to stem the dollar’s slide and, in turn, place a cap on oil. This would halt some of the pain at the pump for consumers – but would probably not push the US currency so high that it would start to harm the humming export sector. Together with easy monetary policy, the dollar helps to cushion the blow from the credit squeeze and the still-unfolding pain in the consumer sector.

Complicating matters now is the stance of the ECB. A rate rise this summer will only weigh further on a dollar backed by a 2 per cent Fed funds rate versus the ECB’s current overnight rate of 4 per cent. With growth slowing in the eurozone and motorists protesting against high petrol prices, a rate hike seems questionable.

But there is little doubt the ECB’s tough inflation stance will pressure the dollar lower. And, in turn, that will boost oil and fan inflation worries, confirming the likelihood of rate rises in Europe, so setting in chain a vicious cycle of further weakness in the dollar.

This leaves the Fed in the difficult position of watching import prices rising further and intensifying pain for consumers. All of which fosters the debate about inflation and possible Fed rate increases this year.

Unfortunately for the Fed, it seems the likely solution for controlling inflation is a hard landing for the economy. A look at range-bound Treasury inflation protected securities shows that investors believe this is the likely scenario. For the next 10 years, inflation is expected to average around 2.5 per cent, according to TIPS.

This thinking is backed by yearly wages growing at 3.5 per cent. Not since the early 1980s have wages grown faster than 4.5 per cent year-over-year and thus provided the fuel for runaway inflation.

For all his jawboning about the dollar, Mr Bernanke is caught between unpalatable choices for a central banker.

michael.mackenzie@ft.com

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