Fed Vice Donald Kohn Urges Emerging Markets to Drop the Dollar Peg

By The Daily Reckoning | More Articles by The Daily Reckoning

Fed Vice Chairman Donald Kohn said the world would be a lot better if emerging markets simply dropped their dollar pegs. This means they would stop importing U.S. inflation by matching the Fed rate cut for rate cut.

In a speech earlier this week Kohn said, "In those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability."

As Aussies know from yesterday’s credit figures, you can reduce aggregate demand in an economy by raising interest rates. But you can’t reduce demand in your own economy if your interest rates and your currency are pegged to the value of the U.S. dollar. This is the dilemma much of the developing world finds itself in.

They are simply going to have to let the U.S. dollar go. The Fed makes rate policy suitable for the American economy. The American economy is bloated with debt and on the verge of a recession. The Fed reckons slow growth is a bigger threat to the U.S. economy than inflation, so it’s leaving rates low.

Sometimes it’s hard to say goodbye. It’s been a decent macroeconomic policy to make things, peg your currency to the greenback, and sell to the American consumer for the last 50 years. He had cash. He had credit. And his appetite for stuff seemed nearly inexhaustible.

But human beings have the same appetites…for calories…for cars…for the good life. And there are a lot of human beings chasing better standards of living. There is plenty of demand in the global pipeline. Anticipating this, the world economy needs to rid itself of its America addiction. But it’s going to have go cold turkey.

The transition toward more domestic consumption in developing economies isn’t going to be seamless or smooth. It’s going to be bumpy. There will be pushing and shoving. For investors, there might not be too many places to keep your money safe. If paper currencies are relatively unsafe, tangible assets may be relatively safer.

The trouble for investors is that rising commodity prices don’t necessarily equal rising share prices for commodity producers. You have to be selective.

We reckon commodities themselves are probably due for a bit of a breather in the second half of the year. The ongoing solvency crisis in the financial sector is going to be a major drag on the share markets. But in the meantime, the long-term trends should favour Aussie resource investors.

Besides, everyone is so gloomy those days. We should know. It takes a gloomster to know a gloomster. We see a lot of gloomsters around. That worries us. Are we missing something?

If everyone is convinced nothing is worth buying and nothing will go up, what does that tell you? Has sentiment gotten as bad as it will get? If the stock market leads the economy, could we see a turnaround in the second half of this year, forecasting the bottom of the credit crisis and U.S. housing prices in the first quarter of next year? More on that tomorrow.