Central Europe
Central Europe: Trip Notes
October 14, 2009

By Pasquale Diana | London

Hungary: Closer to Normal, Panic Days Behind Us

Rates headed lower, in 50bp clips. 6% by year-end feasible: The mood at the central bank was significantly more relaxed than when we last visited in March. Our overall impression is that the MPC will continue to cut at 50bp intervals until rates are at 6% (possibly lower). Only a severe bout of risk aversion or nasty CPI surprises could derail the easing cycle, in our view. We bring forward our 6% terminal rate forecast from 1H10 to December 2009 (or 1Q10 at the latest). Larger, opportunistic moves are unlikely - the July 100bp cut is seen as an exception, unlikely to be repeated. Also, the bulk of the MPC believes that "predictability is an asset in itself" and would not want to risk upsetting markets with erratic policy moves.

FX - EUR/HUF danger zone has moved higher: Everyone we met at the MPC stressed that the recent benign trend in CPI, the lower-than-expected pass-through from the VAT hike and a sizeable output gap (7% of GDP) make HUF gains not a necessary tool for disinflation. Indeed, the latest inflation forecast for August, showing an undershoot in 2010, assumes EUR/HUF at 272. The bank is wary of commenting on levels, but the benign CPI outlook suggests to us that the EUR/HUF ‘danger zone' (which probably started at 290 previously) has moved higher, and gradual (and measured) weakness in HUF would not necessarily be met by a policy response. Note also that recent banking sector stress tests (which assume extreme FX moves) have not shown a deterioration since April (note that the €2 billion earmarked for banking sector support under the IMF package is still available).

FX loans - time to put an end to FX mismatches: The NBH was very vocal about the need to move to a more normal monetary policy set-up, in which policy rate decisions are a function of growth and CPI, rather than financial stability considerations. The steady move away from FX lending to HUF lending is an integral part of this process, of course. As also mentioned in a recent interview, the NBH wants to limit LTV ratios in FX loans to 54% for EUR and 35% for CHF (versus 70% for HUF loans). OTP, the largest local lender, has already stated its opposition to these plans. Ultimately, the decision rests with the government, which has in the past been reluctant to act, given that cheap FX credit was increasing home affordability, and therefore was popular with voters. Central bank officials are aware of the implications of tighter FX loan availability on banks' profit margins, effective interest rates and asset prices, but they think that it is a price worth paying to diminish overall FX exposure, which remains at uncomfortable levels even after most CHF lending has ground to a halt. In the medium term, lower HUF rates should make this process easier by lessening the attractiveness of FX loans.

Medium-term growth slowdown is real: We found generalized agreement in Hungary with our view that the new ‘normal' across CEE might be slower trend growth than in the post EU accession era, due to capital destruction as well as less availability of cheap credit (see above). The implication is slower convergence to the EU average, and a more subdued outlook for HUF and HUF assets.

All eyes on Fidesz: A Fidesz (centre-right) win in the upcoming parliamentary elections is a foregone conclusion. However, local political analysts point to the fact that support for far-right Jobbik is understated in the opinion polls, and they could gain as much as 15% in the elections. This may force Fidesz into an uneasy alliance with Jobbik, or even a grand coalition with the Socialists (the former more likely). Fidesz has an ambitious plan to radically reform public expenditure, which still far outweighs neighboring countries, and potentially move to a flat tax.

However, the full extent of these plans will only become obvious after the elections, as Fidesz has no incentive in associating itself with austerity measures at present. The party is staunchly pro-EMU, but an ambitious euro date is likely to be announced only after fiscal measures to cut the deficit stably below 3% and return the country to a stable growth path have been announced. The majority opinion is that there are limited risks around the budget for 2009, though we would highlight that in September 2009 the budget deficit was already at 107% of the full-year target, and the government plans on CIT inflows paid at year-end to meet its budget goal - which looks risky. The 2010 budget currently under discussion looks conservative (3.8% of GDP target after 3.9% this year), although we heard concerns that some last-minute electoral spending by the Socialists may take place just ahead of the elections. This would leave Fidesz with some fiscal tidying up to do when it comes into office in April-May 2010. Despite its negative rhetoric, Fidesz understands the importance of the IMF plan and market confidence, and will not act to undermine either, in our view.

Poland: Budget Issues Likely Overstated, but No Clear Adjustment Path

Budget assumptions look broadly conservative: The net borrowing requirement goes from PLN 57 billion this year (4.3% of GDP) to PLN 82.4 billion (6.1% of GDP) next year. The assumptions look conservative (1.2% GDP growth, 1% average inflation in 2010), though the 2010 revenue projections are not obviously so (indirect tax receipts up 6%, CIT +10%). The MoF points out that corporate tax receipts this year have been hurt by losses on FX options, which are a one-off and will not be repeated. In addition, the Min Fin feels that it is being conservative on its HH consumption assumption for 2010 (+0.9%Y), and we agree (MS: +1.2%). So, not only might the overall level of growth be stronger, but also its composition may be more revenue-friendly. Importantly, only PLN 9 billion out of PLN 25 billion of privatization receipts in the 2010 target have been earmarked for deficit reduction. The rest will go to a ‘demographic reserve fund'.

Debt ratios are key - 55% is an important signpost: As we already suspected, there is a great deal of sensitivity around not breaching the 55% debt/GDP threshold in 2010, which the government wants to avoid breaching at any cost, given that it entails, in the extreme, running a balanced budget in 2012. To that end, privatization will be used (and the end of the Eureko saga is seen as a plus for investor sentiment). Also, local banks speculate that the Min Fin may even intervene near year-end to push EUR/PLN lower in order to reduce the ratio (26% of government debt is in FX). The 55% ratio could in theory be amended by a majority in parliament (it is not a constitutional threshold, like 60%), but this would be only a last resort.

NBP council and rate outlook - huge uncertainty ahead: While we found strong consensus around the view that the MPC is about to move to a neutral bias and stay on hold into 1Q10, the biggest uncertainty next year is about the composition of the new MPC (9 out of 10 members will be replaced). One of the views presented is that the president will appoint three doves, who will vote with Governor Skrzypek (himself a dove). This would require the ruling PO to appoint six MPC members of hawkish persuasion, if a rate hike is to take place at all next year. We find this approach far too dogmatic, however, as it is possible (even likely) that MPC members will not stick to the ‘party line', but will vote with their judgement. This has indeed happened in the past already. Therefore, there is no easy way to tell whether the next council will be ‘dovish' or ‘hawkish' purely based on political allegiances. One risk around our view that rates may rise already in 3Q10 is that there may be some resistance to taking back monetary stimulus when the unemployment rate is still trending up and growth is lackluster. The new MPC (six-year term) will most likely take Poland into ERM II (or even EMU), so the pro-EMU ruling PO party will seek to appoint members who share its views on the single currency.

Thoughts on medium-term growth: We found much less agreement in Poland than in Hungary on our view that the ‘new normal' in the post-crunch world is a lower trend growth rate. Indeed, one view put forward by a senior academic was that previous periods of strong growth were the result of large ‘growth reserves' being created in a previous recession (2001-02 or 1988-91). According to this view, the current episode is following very much the same script, and a growth spurt in 2012-15 will create the macro backdrop for successful euro adoption. We are a little more pessimistic on growth, but would agree that Poland did not have the sort of unsustainable credit bubble that other countries in the region enjoyed, so its transition to the ‘new normal' should be gentler. Overall, the opinions on growth were positive: having avoided recession this year, Poland should continue to grow faster than its peers in 2010. This was one of the reasons why people were generally constructive on the outlook for the zloty (we agree).

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Peru
Investment Drives Growth
October 14, 2009

By Daniel Volberg | New York

While we are disappointed that Peru's economy has proven less dynamic than we had expected this year, extrapolating the recent weakness into the future may prove to be a mistake.  At the turn of the year we had expected Peru to take a unique place among the Latin American countries as the only economy to avoid a contraction this year despite the most serious global recession in six decades.  We still expect positive annual growth in 2009, but the economy has proven less dynamic than we had expected, lagging some of its neighbors in pulling out of the downturn.  Sequentially, Peru has contracted 0.5% in 1H09, underperforming Brazil (+0.5%) and Colombia (+0.5%).  Looking ahead, however, Peru's economy may be ready to turn the corner and roar out of the gates as we head into next year.  Indeed, we expect Peru to post one of the stronger rebounds in activity among its Latin peers on the back of a rebound in domestic demand.  Therefore, we are revising our forecasts for GDP growth to 0.9% (from 1.8% previously) for 2009 and to 4.9% (from 4.4%) for 2010.

Growth Composition

Net exports provided the bulk of growth support during 1H09.  It is hardly a surprise that a sharp downturn in domestic demand during 1H09, driven by a contraction in private investment, has pulled down imports (-18.8%) much more than exports (-2.6%).  Indeed, this is the story for virtually all the region's larger economies.  Indeed, in dollar terms, the value of imports of intermediate and capital goods - items closely associated with domestic investment - plunged 33.1% in the six months through June.  And we have yet to see any relief from the downturn in these investment-based imports - in July-August they contracted by 36.4%Y.  Meanwhile, export demand has remained relatively resilient.  After all, Peru's exports are largely primary goods, which benefitted from Chinese stimulus and relatively resilient global demand, as well as gold, which benefitted from the search for a safe haven in the midst of the financial market turmoil.  As a result, net exports contributed 3.7pp to growth in 1H09.

And the authorities have ramped up fiscal stimulus in an attempt to cushion falling growth.  The authorities provided two kinds of stimulus - monetary and fiscal.  While we expect that both may ultimately be important in helping to cushion the fall, we estimate that fiscal stimulus has been more effective in the near term.

On the monetary front, the central bank slashed rates by 525bp between February and August, bringing the policy rate to a historical low of 1.25%.  However, so far the effectiveness of monetary stimulus has been limited as credit growth, particularly consumer credit, continues to decelerate in real terms.  But this is hardly surprising - monetary policy works with a lag and we would expect the effect of the sharp decline in policy rates to filter through to the economy only around the middle or end of next year.

Meanwhile, fiscal stimulus has been effective in delivering some relief to the downturn in growth.  Public investment expanded near 17%Y in 1H09, a light deceleration from the 26% growth pace in the previous three years.  And public consumption grew 8.5% in the same period, significantly higher than the near 5% average growth in 2006-08.  The mix of fiscal stimulus - more emphasis on public consumption than public investment - reflects the difficulty that the authorities have faced in executing public investment projects efficiently.  Instead, they have relied more heavily on lifting public sector wages and other current expenditures. Public consumption and public investment jointly contributed a little over a percentage point to overall GDP growth in both 1Q and 2Q09.

Still, despite the stimulus and the positive contribution from net exports, GDP growth has suffered from a contraction in private investment and a destocking cycle.  Private investment sequentially contracted 7.3% on average in 1H09 or 7.0% in annual terms. This contraction comes in sharp contrast to the +23.8% average annual growth in the previous three years.  Indeed, the weakness in private investment has pulled down domestic demand by 3.4%Y in 1H09.  And this downturn in domestic demand came despite positive growth in total (public and private) consumption (+3.3%).  Indeed, the contraction in private investment took overall GDP down by 2.2pp in 1H09, with the bulk of the contraction concentrated in 2Q.  Meanwhile, destocking knocked off, on average, 4.3pp during 1H09.

Investment Prospects

Looking ahead, we suspect that Peru's economic recovery hinges primarily on the outlook for private investment.  After all, if not already over by June, the destocking cycle may have largely ended in 3Q since the drawdown in inventories has been substantial during 1H09.  Gauging prospects for private investment may be tricky, but we suspect that investment should rebound strongly in the months ahead for two reasons.

First, we expect foreign direct investment (FDI) to remain resilient as we head into 2010.  With the prices of commodities that Peru exports - copper, gold, zinc, tin and silver - rebounding from the lows at the turn of the year, the mining projects that may have been mothballed just a few months ago are coming back to life and new projects are starting.  After all, FDI has rebounded to near its medium-term level already in 1Q09, after a sharp downturn at the end of 2008.  And the 1Q rebound was no fluke.  We have tallied up a bottom-up assessment of the FDI projects that are in store for this year and next.  We use these numbers with some trepidation - after all, information about future FDI projects tends to be confidential.  Thus, we suspect that our tally is likely a lower bound on FDI prospects for this year and next.  For 2009 we expect US$3.5 billion in FDI inflows - an equivalent of near 3% of GDP.  This is in line with the 3.3% of GDP average FDI inflow in the last ten years.  And for 2010 we expect FDI of at least US$2.5 billion or near 2% of GDP.  This is a substantial pace of investment, but with global markets healing and commodity prices continuing to gain ground, we suspect that FDI inflows next year may further surprise on the upside.

Second, we expect domestic investment to turn around next year.  One key feature of the downturn in activity this year has been continued, uninterrupted growth in consumption in annual terms.  True, sequentially private consumption contracted in 1Q - we estimate -1.5% from the previous quarter.  But, sequentially, private consumption growth turned around already in 2Q09 - we estimate +0.5% growth after seasonally adjusting the data.  And public consumption has been firing on all cylinders as the authorities ramped up current spending to stimulate the economy.  Given the turnaround in consumption and the sharp destocking that took place during 1H09, we think it is only a matter of time before final demand pressure pushes firms to invest in capacity expansion.  Indeed, our estimates of capacity utilization show that after peaking in August last year, capacity utilization has hit bottom in April and has been rebounding sharply since.  And survey data of large and medium-sized firms suggest that they are indeed intending to ramp up their investment plans.  We find that a net 28% of all firms surveyed in 3Q expect to lift their investment plans in the months ahead, a sharp turnaround from the expectation of a decline in investment plans by a net 12% of the same firms surveyed in 1Q.  As markets around the world continue to heal, we expect domestic business sentiment in Peru to continue to recover and further reinforce what the data already suggest - in Peru the household demand recovery is sustainable and firms need to restart their investment plans to keep up with it.

Forecast Revisions

With consumption recovering already and investment set to follow soon, we are revising our GDP growth forecasts.  We are downgrading growth in 2009 to 0.9% (from 1.8% previously) on the back of recent data and near-term leading indicators.  However, we are upgrading our forecast for 2010 growth to 4.9% (from 4.4%).  The biggest driver of the new revised forecasts is a stronger pace of investment next year after a sharper-than-expected downturn in 2009.  We are revising our exchange rate forecast to 2.85 (from 3.2 previously) for 2009 and to 2.8 (from 2.9 previously) for 2010.  With investment leading the expansion in activity and with overall growth below potential, we expect inflationary pressures to remain subdued for a prolonged period and are revising our inflation forecast to 0.2% (from 1.9% previously) for 2009 and to 2.2% (from 3.4% previously) for 2010.  In line with the more benign inflation scenario, we now expect the emergency monetary policy easing to be taken back less aggressively next year, and are revising our interest rate forecast for 2010 to 4.75% (from 6% previously).

Bottom Line

Peru has proven less resilient to the downturn than we had expected after we revised up our regional outlook back in June.  But now may be the wrong time to turn negative on Peru's growth outlook, in our view.  With consumption already turning the corner, destocking almost over and investment on the verge of reigniting, we expect Peru to be one of the faster-growing economies in the region next year.  But given Peru's relatively high growth potential, we expect inflationary pressures to remain limited and allow the central bank to maintain rates at a record low until 2H10 amid a gradual appreciation of the currency.

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United States
The Dollar and Monetary Policy
October 14, 2009

By Richard Berner | New York

Controversy swirls around the dollar's recent decline.  Some observers fear that by keeping monetary policy easy and allowing the dollar to fall, the Fed is playing with fire: They worry that the central bank risks pushing inflation higher or that the policy could trigger a destabilizing crash in the currency.  Indeed, the financial press is replete with ominous warnings: "Dollar Adrift ...U.S. Stands By as Dollar Falls...," and markets appear to echo those concerns, as gold and other commodity prices are soaring. 

Misplaced concerns.  In my view, those concerns are misplaced, especially in today's context.  I think a weaker dollar is a helpful adjunct to US monetary policy: It helps prevent already-declining inflation from falling too low and is a stimulant to growth for an economy that could well use more vigor.  Monetary policy should aim to maintain the purchasing power of the currency, and this means avoiding deflation as well as inflation.  Core inflation at 1.3% and falling is well below the cushion of safety that is needed to guard against future disinflationary shocks.  In addition, a decline in the dollar helps to boost US net exports and earnings - with a lag - and the effects of this ongoing depreciation should last through 2010.

Preconditions for a currency crash are not evident: The dollar's recent slide is only reversing a substantial rise that began in mid-2008; on a broad, trade-weighted basis the dollar is actually 8% stronger than it was at that time and now stands about where it was two years ago.  Moreover, the depreciation has been orderly and has been accompanied by falling, not rising, risk premiums.  And one key driver - the US current account deficit, which is a measure of US external financing needs - has shrunk to less than 3% of GDP, or half its peak value. 

Disinflationary forces dominate inflation for now.  There is broad agreement that a weaker dollar can contribute to higher inflation, both through its direct influence on import and commodity prices and via its indirect impact on inflation expectations.  The interplay among them is important: While a weaker dollar and rising commodity prices will primarily change relative prices, like those of imports and energy goods and services, they can nonetheless influence both inflation expectations and inflation itself.

In our view, a weaker dollar and rising commodity prices are tangible evidence of the Fed's reflationary thrust.  Since the Fed stepped up its quantitative easing at the March 18 FOMC meeting, the dollar has declined on a broad, trade-weighted basis by 8.7%, crude oil quotes have jumped by 46%, and broad commodity price indexes have risen by 18-26%.  To be sure, the dollar's recent decline reflects greatly reduced risk-aversion, and rising commodity prices also are a sign of investors' increased appetite for risk amid hopes for global recovery.  But they are all part of the policy transmission process.  Although exchange rate ‘pass-through' has weakened in recent years, it isn't zero.  A weaker dollar will help to limit inflation downside through import prices, commodity prices and inflation expectations. 

However, none of these forces yet suggests the danger that monetary policy is too accommodative.  On the contrary, inflation is likely to decline over the next several months, for two reasons.  First, the impact of a weaker dollar on inflation takes longer and is smaller than many believe, courtesy of lags between changes in exchange rates and the subsequent rise in import prices, together with the diminishing importance of exchange rates for US inflation in a globalized world and their smaller impact in recession, when it is more difficult to pass through such costs into inflation.  More importantly, domestic disinflationary forces are for now dominant and are pulling inflation lower. 

The cyclical behavior of inflation expectations thus reflects the tug-of-war between the boost from unprecedented monetary ease - both in terms of rates and quantities - and domestic disinflationary forces that are depressing them.  Five-year, five-year breakevens have drifted sideways at about 2.25% since the summer.  While TIPs yields are still distorted by liquidity premiums and the Fed's US$300 billion Treasury Asset Purchase Program, the direction of movement likely is suggestive of investors' inflation expectations.  The Michigan survey indicated that 5-10 year and 1-year inflation expectations both declined, respectively to 2.8% and 2.2% over the past three months. 

Disinflationary forces.  Unprecedented slack in the US and global economies is still acting as a brake on inflation, and we think it will for now stymie pricing power for companies around the world.  Intuition and the fact that inflation typically falls well after recessions end support that view.  Yet casual empiricism suggests that neither the ‘output gap' - the difference between potential and actual GDP - nor capacity utilization are highly correlated with inflation; simple correlations between the output gap or operating rates and either headline or core CPI (or the PPI) are -0.33 or less.  Moreover, these correlations appear to be unstable over time.

However, careful empirical work shows that, adjusted for inflation expectations and supply shocks, the output gap (or other measures of slack such as operating rates) is a highly useful guide to future inflation.  That's despite the fact that the so-called Phillips curve seems to have become flatter (i.e., a given change in slack has a smaller influence on inflation, raising the so-called ‘sacrifice ratio') over time, which may reflect the success of monetary policy.  Even if the influence of slack on inflation is smaller than in the past, there's no mistaking the fact that slack in the US economy has rarely been larger.  The output gap stands at 7.6% (its largest level since 1983) and operating rates have plunged to record lows of 64%.  The good news is that ‘capital exit' and a lift to production is reducing both from record territory.  In addition, slack affects inflation dynamics: The level of the output gap appears to affect changes in inflation, as it affects the extent to which firms can push through changes in energy and other costs, and changes in the output gap appear to affect inflation, as firms sense that recession or recovery accompanies falling or rising pricing power. 

The effects of growing slack are widespread in housing and labor markets.  Slack in housing markets has promoted a sharp deceleration in rents.  The increases in owner's equivalent rent and apartment rents have slowed to record lows of 1.7% and 2% in the year ended in September.  Likewise, slack in labor markets has promoted a deceleration in wages.  Measured by the Employment Cost Index, wages and salaries of private industry workers decelerated to 1.5% in 2Q - a record low.  Coupled with better-than-expected productivity gains, the resulting performance of unit labor costs may also be disinflationary.

Forces affecting growth.  Although the lags are long, a weaker dollar is stimulative; it will boost exports and shift production to the US.  That's still a forecast; the recent rise in exports probably owes more to the pick-up in global growth than to the improvement in competitiveness that a weaker dollar has conferred on US exporters.  Real merchandise exports have rebounded at a 14.5% annual rate in the three months ended in August, but they are still down 19.5%Y.  Likewise, it's premature to argue that the recent slide in the dollar is shifting production away from imports and back to the US.  Indeed, soaring imports of motor vehicles and parts (associated with the rebuilding of depleted inventories) have paced a 15.2% annualized rebound in real merchandise imports in the past three months. 

But looking back over a longer time period, it does appear that the dollar's long slide is paying off.  From its peak in 2002, the broad, real effective trade-weighted dollar index declined by 22% through end-2007.  Correspondingly, in the three years leading up to the recession that began in December 2007, growth in US real exports of goods and services outpaced growth in non-US GDP by more than 3 to 1, the highest such ratio in two decades.  Likewise, growth in real imports of goods and services over that period slowed to just above the pace of US real final domestic demand.

That's not all.  The dollar's decline will also boost the earnings and cash flow of US affiliates abroad and thus of US corporates overall, adding to wherewithal for financing investment.  In this regard, the dollar works through two familiar channels.  First, it translates earnings in euros, reals or Canadian and Aussie dollars into more US dollars.  And it makes those affiliates more competitive in the markets they serve, to the extent they source products and services from the US.  Finally, the dollar's decline will add to the sustainability of both US and global growth by making it more balanced.  Because the US relies more on exports and our trading partners rely more on domestic demand, our trade deficits and their trade surpluses will shrink.  Correspondingly, while we rebuild domestic saving, we'll rely less on borrowing from abroad to finance growth in demand. 

Criteria for tolerance.  Our FX strategy team believes that further declines in the dollar are likely, reflecting four fundamental factors.  Investors are seeking higher returns outside the US in both equities and fixed income; risk-on trades are bad for the dollar's role as a safe haven; the Fed's commitment to keep rates low and QE have begun to make the dollar a funding currency; and the US current account deficit has bottomed and will likely widen again in the next couple of years.  We believe that a significant portion of the narrowing in the US current account deficit reflects the recession, and while the external imbalance is unlikely to return to its previous peak of 6% of GDP (in 2006), the US recovery is likely to promote a widening in the current account deficit from 3% to 4% of GDP.  In other words, until US-overseas growth and return differentials shift in the dollar's favor, a dollar rebound seems unlikely.  And as noted above, the dollar's decline supports US policy goals. 

However, US officials will not tolerate a weaker dollar under any and all circumstances.  They will do so as long as the move is orderly and follows those fundamentals.  We distinguish orderly from disorderly by looking to pace and risk premiums, and whether market participants think there is a one-way bet on the currency.  In view of the recent exchange rate history discussed above, it would be hard to argue that the pace has been excessive.  Moreover, risk premiums in sovereign debt and risky assets have been falling over the course of the dollar's decline since March. 

Historical perspective.  To appreciate what's really involved in disorderly currency markets, it may be helpful to review the circumstances surrounding the most recent US currency crisis, in 1978.  Last May I wrote about the lessons from that episode:

"The dollar plunged by nearly 14% in the year ended late October 1978, as rising inflation, the Fed's lack of resolve to bring it down, and Treasury Secretary W. Michael Blumenthal's stated policy of ‘benign neglect' towards the currency undermined investors' confidence in the dollar's value.  That was a true currency crisis, rooted in major policy blunders.  Policymakers long ago learned from those policy mistakes and aren't likely to make them again.  So a dollar crisis from that source is highly unlikely.

Officials took aggressive action to end the 1978 crisis.  On November 1, 1978, the Fed and Treasury were forced to launch an emergency rescue package, including a 100bp hike in the Federal funds rate, a $30 billion package of FX swap lines, sales of SDRs, tapping the US reserve position at the IMF, and issuance of so-called Carter Bonds.  More important, that era clearly set the stage for the Fed under Paul Volcker - and central banks generally - to focus on bringing down inflation and maintaining price stability.  The Fed's independence and commitment to capping inflation should give investors confidence in the dollar's value over time.  However, we believe that significant increases in interest rates likely will be needed to achieve those goals over the next couple of years."

Criteria for pushback.  The move in the dollar since March has been orderly, but that doesn't guarantee it will persist.  Indeed, officials are aware that the risk of a one-way bet on the currency is rising: Dollar sentiment is almost universally bearish, and selling the dollar has become a crowded trade.  As a result, officials may want to put some two-way risk back into the dollar on most currency crosses.  Officials will resist too rapid a move with rhetoric and hints of intervention.  Indeed, recent concerns about the euro's strength have prompted comments from ECB President Jean-Claude Trichet.  And Asian central banks last week intervened to slow the rapid appreciation of their currencies. 

But actual US or other G10 intervention is unlikely, barring disorderly markets.  Officials are aware that success in FX intervention requires three favorable preconditions: It must start with the wind at their backs - the currency must be moving in a new direction.  It must be coordinated; unilateral intervention to defend a weakening currency rarely works.  And it must not fight the thrust of policy.  Ultimately, therefore, the fundamentals of external imbalances, growth, investment returns and monetary policy differentials will dictate the currency's path.  Thus, until the US outlook warrants a reversal in US monetary policy, the dollar likely will continue to depreciate.

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