* Finally, Minneapolis Fed President Narayana Kocherlakota, who was known as a monetary policy hawk, has recently shifted to a more dovish stance. He surprised the market with remarks supporting the Fed's decision to keep rates extraordinarily low until the unemployment rate has fallen below 5.5%, as long as inflation remains below 2.25%. Kocherlakota will be a voting member in 2014, but his shift of stance will weaken the hawkish voice. With fewer dissidents on the board, the Fed may continue to err firmly on the side of inflation and stick to to its mid-2015 low rate pledge.
No matter who wins the election, we will see a policy dilemma for the Fed in the coming years: On the one side, should economic data continue to surprise to the upside, it will be increasingly difficult for the Fed to carry on its dovish policies. On the other side, if the Fed were to abandon its current commitment, we foresee rising market volatility. The U.S. economy is likely to face a "monetary policy cliff" in addition to the "fiscal cliff". With easy money, inflation risks may well continue to rise, possibly imposing higher bond yields (lower bond prices) and a weaker dollar. With tight money, the Fed may induce a bond selloff. Historically, because foreigners are active buyers of U.S. bonds, the dollar has weakened during early and mid-phases of tightening, as the bond bull market turns into a bear market. It's only during late phases of tightening that the dollar has historically benefited as the bond market turns yet again into a bull market. We encourage investors to review their portfolios to account for the risk that bonds may be selling off, taking the U.S. dollar along with it.
Axel Merk
Axel Merk is president of Merk Investments, manager of Merk Funds, is an authority on currencies and a pioneer in using strategic currency investing for diversification and down-side protection. Merk is an expert on the global economy, macro trends, monetary policy, and the implications to the U.S. dollar and investing.
Yuan Fang is a Financial Analyst at Merk Investments and member of the portfolio management group.
Merk Investments, Manager of the Merk Funds.