There has been a lot of speculation about the possibility of currency intervention in the US dollar. In the past year alone, the US dollar has fallen 15 percent in value against the Euro, 18 percent against the Swiss Franc and 13 percent against the Japanese Yen. Over the past 3 years, the decline has been more than 25 percent. Interestingly enough, the prospect of intervention is more real than it was back in April, when the US dollar hit a record low against the Euro. What changed? Inflation.

Last week, oil prices climbed to an all time high of $139.12 a barrel, sending inflationary pressures skyrocketing. Central banks around the world turned aggressively hawkish as the threat of higher prices solidified their need to focus on containing price pressures. Even the Bank of Canada has succumbed to higher inflationary pressures – they were widely expected to cut interest rates by 25bp this morning, but they opted to leave interest rates unchanged at 3 percent instead.

Clear and Cohesive Message from the Bush Administration: Stronger Dollar

Over the past week, the Bush Administration has sent a surprisingly clear message to the markets about where they want the dollar to head. The comments from 3 important people represent clear cohesion within the Administration, who has come out with all guns blazing:

Last Tuesday, Federal Reserve Chairman Ben Bernanke broke from tradition and talked about currencies. He drew links between the weaker dollar and higher import costs and consumer price inflation. His cohorts including Fed President Geithner confirmed that the central bank is paying “very close attention” to the value of the dollar.

On Monday, US Treasury Secretary Paulson said that he would not rule out any policy tool including currency intervention

Last night, on Airforce One, President Bush told The Times of London that “we want the dollar to strengthen.”

With gasoline prices now above $4 a gallon across the nation, the central bank has made reducing inflationary pressures their number 1 priority. According to Ben Bernanke’s comments Monday evening (Full Speech), the FOMC will “strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.” Bernanke even went so far as to say that despite the fact that the unemployment rate jumped from 5 percent to 5.5 percent, which was very negative since it marked the largest monthly decline in over 20 years, the US economy has skirted a major decline.

In all likelihood, the central bank governor’s more moderate comments about the outlook US economy is an excuse to keep monetary policy unchanged as it is too early to decide whether the US economy has indeed averted a more serious slowdown. The jump in gas prices is a major risk to consumer spending and it remains to be seen whether that will have a more serious impact on the overall economy.

Since the economy is not strong enough to raise interest rates, the Federal Reserve and US Treasury hopes that an appreciation of the US dollar would help to curb inflation, but we believe that they will stop short of physical intervention.

Stopping Short of Physical Intervention?

The last time that the Federal Reserve intervened in the currency markets was shortly after the launch of the Euro. At that time, the currency fell to a low of 84 cents, triggering panic for the European Central Bank. In response to the sharp sell-off in the EUR/USD, the ECB convinced the Fed to jointly intervene in the currency markets to buy euros and sell US dollars. Since then there has been no intervention for more than 7 years, which means that stepping into the markets at this time would represent a dramatic policy shift for the US government.

The Alternative: Verbal Intervention at G7/G8?

The alternative on the other hand may be verbal intervention at this weekend’s G7/G8 meeting. Given that the weakness of the US dollar has been one of the primary reasons why food and energy prices have skyrocketed, a stronger dollar may be in everyone’s best interest. Or is it? For the US government to support dollar strength, half of the battle for verbal intervention may have already been won. However, it is the European Central Bank that really needs to be convinced. With the ECB on a mission to do all that it takes to lower inflation, they may not be willing to let the Euro weaken.

Over the past 30 years, G7/G8 meetings have marked major turning points for the US dollar.

According to the following G7 chart, significant tops and bottoms have coincided with a significant change in the foreign exchange language of the G7 communiqué. For example, following the Dubai meeting in 2003, the Group of Seven called for more “flexibility in exchange rates.” Although this criticism was directed at China and Japan, it came on the heels of a strong dollar rally. The decline of the US dollar during the late 1980s was also halted when the Louvre Accord was signed in 1987 at the G7 Minister of Finance meeting. Even though the language in the communiqué is only changed every few years, G7 meetings matter because they have the potential to make or break the US dollar.

Whether or not the G7/G8 meeting in Osaka Japan will matter this time around will depend upon how many members support a change in the FX language of the communiqué. If it is just the US, the results may be ineffective, but if it is supported by all of the members of the G8, that is completely different story. Bear in mind though that the upcoming meeting will only be attended by Finance Ministers and not central bankers. Therefore it remains to be seen whether changes will be made without the presence of the ECB and the Federal Reserve.