Faced with the threat of deflation, the Federal Reserve (Fed) may be trying to drive the dollar lower to spur inflation. As policy makers don't want home prices to deteriorate further, an alternative is to inflate the prices of all other goods and services: as a result, the relative prices of homes would be less expensive. Weakening the dollar is an effective policy tool to drive up inflation as the cost of import goes up. Just be careful: the Fed may be getting more than it is bargaining for. Fed Chairman Bernanke believes that a weaker dollar will only drive up inflation modestly; in our humble opinion, we believe he may be mistaken. Foreigners have a limit on how much margin pressure they can absorb before they have to pass on the higher cost of doing business. We saw this phenomenon in the spring time, when higher commodity prices forced Asian exporters to drive up prices; import prices into the U.S. were up over 20% year over year (and still up substantially after factoring out what was soaring oil prices at the time). No country has ever depreciated itself into prosperity and the U.S. is unlikely to be the first.

The Fed has been progressively more aggressive in attacking the dollar. Low interest rates are the traditional policy tool to make a currency less attractive. Short-term interest rates are now at historic lows; interest rates set by the market rather than the Fed are even lower.

Since late September, the Fed has been flooding the banking system with liquidity. By creating money with its printing press, the Fed literally provided hundreds of billions of dollars to the banking system. The Fed does so by buying assets from banks. At first, the program was partially "sterilized" as the Fed provided good quality bills in exchange for whatever the Fed received from the banks. Since then, however, the Fed no longer mops up the liquidity in such transactions and simply provides cash to the banks. Banks, rather than using the money to lend, have hoarded the cash. That's why some observers claim these actions have not been inflationary as bank reserves are increased, but the money supply in the economy is not. Excess reserves in the banking system, traditionally less than $2 billion, are now about $600 billion.

We believe the excess reserves by the banks will be lent to the public, not private sector. While some money is starting to be used for lending (Verizon was recently able to receive a $17 billion loan to refinance debt in the largest debt offering this year), we believe banks continue to be too weak and don't think the private sector is strong enough either. Further, the unprecedented amounts that need to be financed next year by the U.S. government will crowd out the market: there may not be enough money for the refinancing of U.S. corporate, European corporate or emerging market corporate and government debt available, keeping the cost of financing high for all those players.

The Fed will be aggressive at lending to those sectors of the economy where it wants to see borrowing costs low. The Fed has announced it will buy agency securities (Fannie & Freddie mortgage securities to keep the cost of home ownership low), Treasury bonds and, according to the Fed minutes released December 16, 2008, will "consider ways of using its balance sheet to further support credit markets and economic activity." Using the balance sheet means to issue cash created on a keyboard to buy assets in the markets.

As the Fed buys assets in the market, the Fed drives prices higher; in case of debt securities, the yields will be driven lower. Superficially, this will be perceived as good news as the cost of borrowing is kept low for those who are affected by the purchase programs. For example, mortgage rates may remain low. Note, however, mortgage rates are low for those who qualify for a loan, not for everyone. While many are euphoric that the Fed keeps the cost of borrowing low, there are potentially severe unintended consequences. Specifically, through its direct purchases of securities, asset prices are artificially high. Why would private sector participants buy these securities? The Fed risks becoming the backstop of all economic activity with its action. While the Fed has the printing press, it does not have unlimited manpower: there may already be more acronyms in the Fed's toolbox than staff members. The Fed cannot replace 8,000 banks, but is on its way to doing so. Think of the credit markets: by providing companies like GE direct access to the Fed for its commercial paper needs, GE is kept afloat, but the credit markets remain seized up. The Fed urgently needs to rework its programs to encourage private sector participation, rather than substituting private sector activity.

Importantly, foreign investors are also told their money is not welcome. Foreigners in recent years have been buying the bulk of U.S. Treasury and agency debt. But if these prices are driven artificially high (the yields artificially low), at the very least on the margin - foreign buyers may abstain. Further, Asian investors in particular need their money at home as a domestic stimulus within China is far more efficient than to try to prop up the U.S. economy with debt purchases. The Fed may be able to keep the yield on securities low, but it does so at the expense of the dollar.

The Fed is faced with far greater challenges than Japan. In Japan, there were few foreign creditors. Further, in Japan, all yields - both government and corporate - were low. In the U.S., while the cost of borrowing for the government is low, the private sector is faced with very high financing costs. Rather than the "quantitative easing" that we saw in Japan where the Bank of Japan targeted the reserve levels at banks, we will see a "qualitative easing" in the U.S., where the Fed is going to be closely involved in allocating credit to sectors of the economy it wants to stimulate. This sort of interference with market prices will have unintended consequences, costly side effects. In our view, these will play out in the currency markets. Watch that dollar carefully.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.