Fed eyes dollar drop, but hews to low-rate pledge

Federal Reserve Chairman Ben Bernanke, in a rare comment on the U.S. dollar's value, on Monday acknowledged the currency's slump was causing some prices to rise, but said other factors restraining inflation were winning the day.

While showing he was not indifferent to the dollar's slide, Bernanke said tight credit and a weak job market would weigh on the economy's recovery, and he repeated the Fed's pledge to keep interest rates exceptionally low for an extended period.

We are attentive to implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability, he told the Economic Club of New York.

Bernanke said the central bank's commitment to its dual objectives, along with the strength of the U.S. economy, would help ensure that the dollar was strong and a source of global financial stability.

The dollar initially rose on his comments, but fell back later in the day, hitting a 15-month low against a basket of six major currencies. Gold prices hit record highs and oil prices settled up more than 3.0 percent as the dollar weakened.

A weaker dollar typically supports commodity prices because dollar-priced contracts -- such as those for oil and gold -- become cheaper for buyers using other currencies.

U.S. stocks rose broadly on Monday, sending indexes to 13-month closing highs, on reinforced expectations that interest rates would stay low for a long time.

The Fed slashed U.S. overnight rates to near zero in December to support a recovery from the deepest U.S. recession since the Great Depression.

Bernanke just locked the Fed into an easy monetary policy, at least in the short term, so any implicit threat of response to dollar declines simply has zero credibility, said Stephen Stanley, U.S. economist at RBS.

Fed officials usually defer to the U.S. Treasury Secretary on issues relating to the dollar's value, although Bernanke has commented on the currency in the past.

The dollar had risen in 2008 as the financial crisis spurred investors to turn to the greenback as a safe haven, but it has lost about 16 percent since mid-March this year as risk appetite has returned.

These safe-haven flows have abated, and the dollar has accordingly retraced its gains, Bernanke said.

The dollar's decline this year has sparked concern from Paris to Beijing. In Europe, policy makers worry that the strength of the euro is harming economic recovery prospects while the dollar's drop has eroded the value of the Chinese government's massive holdings of U.S. Treasury debt.

Chinese banking regulator Liu Mingkang said on Sunday that low U.S. interest rates and a weak dollar posed a new systemic risk because they were fueling speculation in overseas asset markets, a particularly pointed criticism with U.S. President Barack Obama visiting China.

NO BUBBLES

But despite warnings from overseas that asset bubbles are building, both Bernanke and the Fed's number two official, Donald Kohn, said they see no compelling evidence this is the case.

Kohn, in a speech in Chicago, defended the Fed's low interest rate policy, saying one aim was to encourage investors to move into riskier assets to promote economic recovery.

Prices in U.S. financial markets do not appear to be clearly out of line with the outlook for the economy, he said.

Both Bernanke and Kohn argued that if bubbles were to emerge it would be more appropriate to combat them with regulation than with the more blunt tool of monetary policy.

This conclusion, that monetary policy is not well-suited to address and resolve asset price bubbles, is dovish insofar as many investors are of the mindset that ... rising asset prices will cause the Fed to hike sooner, said Michael Feroli, economist at JP Morgan.

While Bernanke renewed the commitment to ultra-low rates for an extended period, he cited crosscurrents in the inflation outlook. He said significant changes in economic conditions could change the outlook for policy as well, suggesting the Fed would act if the dollar begins to unravel in a disorderly way.

Dallas Federal Reserve Bank President Richard Fisher said in Tyler, Texas, that the currency's decline had been orderly, but that the central bank was aware its commitment to low rates could fuel speculative activity.

Bernanke noted that the currency's decline had helped push commodity prices higher. However, he also said a high level of slack in the economy and stable longer-run inflation expectations should keep price pressures under wraps.

On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time, he said.

He said the Fed would closely monitor inflation expectations, which can offer an early warning signal of whether an inflationary psychology is building.

Most gauges of inflation expectations have stayed within the Fed's comfort zone, although the Reuters/University of Michigan survey of consumers on Friday showed five-year inflation expectations rose for a second month in November.

Bernanke said that while the economy appeared to be in the early stages of recovery, how it will fare once government stimulus measures dry up is uncertain.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely, he said.

Like Bernanke, Kansas City Federal Reserve Bank President Thomas Hoenig said in a speech in Abu Dhabi that the U.S. economy still faced significant weaknesses.

(Additional reporting by Angela Moon in New York, Karen Pierog in Chicago, Mark Felsenthal in Washington, Pedro Nicolaci da Costa in Tyler, Texas, and Martin Dokoupil in Abu Dhabi; Editing by Andrew Hay and Leslie Adler)