Perceptions unsettle markets and drive the dollar down.

The bearish attitudes toward U.S. domestic bonds and toward the dollar on foreign exchange markets over the past several weeks have probably been as much influenced by market psychology as by economic fundamentals.

Both the attitude of the U.S. administration toward the value of the dollar on exchange markets and the process by which the Fed has chosen to implement monetary policy have contributed to market uncertainties, perhaps unavoidably.

But at the same time market participants themselves, with so much at risk, have sought an unreasonable degree of clarity in a difficult practical situation.

A Feeling for Reality

Much of the weakness in bond and also stock markets in the earlier months of the year was probably related to a market perception that key policymakers in the administration -- at the White House and the Treasury -- did not care if the dollar declined on exchange markets, especially against the Japanese yen.

In fact, so the thinking went, the administration may have countenanced a decline because it would pressure the Japanese to make more concessions in the current trade dispute.

Unfortunately, once a government is perceived to be little concerned about keeping its currency strong, the market will naturally begin to lose confidence in the currency, and international investors will back away from the country's assets.

This is particularly true for a key currency like the dollar, which is the main investment vehicle for the world's international currency reserves and for private international investment portfolios.

Doubts Broaden

As it became clearer that the U.S. economy was fairly strong and was moving toward its output potential faster than earlier expected, doubts about the currency were more surely translated into weakness in domestic bond and stock markets.

This happens because from an investor and indeed from a broad U.S. macroeconomic viewpoint, a policy that encourages a strong, not a relatively weak, dollar would instead be best for an economy nearing its growth potential. Such a policy would hold down interest rates by attracting international funds and would also work against inflation.

When the weakness in the dollar against the yen was also communicated more broadly to other key currencies such as the German mark, the Administration did begin to change its posture.

Statements in support of the dollar became increasingly strong and a concerted international intervention to support the dollar was arranged, though the extent of U.S. commitment to a stronger dollar remains subject to doubt.

While the markets have been confused by the U.S. dollar policy, they have also had to react to the Fed's announced intention to achieve a more "neutral" real federal funds rate (the market funds rate less the current rate of inflation). The Fed has started the process by raising the market rate in small increments.

To date, we have had three 1/4 percentage point increases. More increases are expected, but how many, how large, and how soon are great sources of market confusion.

The Fed has become more forthcoming than in the past about its current policy stance by announcing each change in the funds rate. Nonetheless, justifying these policy changes by indicating that it was moving toward a more "neutral" real rate has, in my view, added confusion and uncertainty to the market.

It had been, and I assume still is, an article of faith at the Fed that a central bank should avoid announcing future interest rate objectives on the grounds that the market will move there immediately -- a move that may in practice be premature and also ultimately inconsistent with policy since neither the Fed nor anyone else can really be certain of such an objective. More economic harm than good would be achieved.

The Fed has, of course, not indicated any ultimate objective for the market federal funds rate. Still, many market participants have been busily attempting to judge through historical comparisons and from guesses about future inflation what overnight market rate level would best fit the Fed's "neutrality" criterion.

Up in Anticipation

Clearly, such a rate would be higher than it currently is. As a result, other market rates that the Fed does not control have moved up sharply to anticipate a higher overnight rate.

And some rates at the longer end have moved up even further on the fear that the Fed's slow progression toward "neutrality" would in fact rekindle inflation -- a fear that, in my view, is overblown and in any event surely premature.

In such a market environment, it is likely that the Fed will have to tighten further, in part to calm market expectations. Still, one would hope that market confusion and uncertainties do not force a tighter posture than underlying economic conditions call for.

Market uncertainties would be allayed under current circumstances if the U.S. administration was perceived as favoring a relatively strong dollar, if international economic policy relationships became more harmonious, and if the Fed could avoid arousing the market's worst fears about the future of interest rates.

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