The U.S. dollar collapsed to two-year lows against the euro as the Federal Reserve (Fed) takes its focus away from fighting inflation. The Fed has a dual mandate: price stability as well as full employment. With unemployment hovering near historic lows, why does the Fed neglect its mandate to fight inflation, thereby jeopardizing the dollar?

Inflation has been creeping up throughout the economy, now showing up even in the "core inflation" statistics the Fed pays particular attention to. At the same time, the signs of an economic slowdown become ever more apparent. Fighting a slowing economy versus fighting rising inflation require diametrically opposed monetary policies. Given the low unemployment rate, rather serious reasons must exist for the Fed to deviate from its mandate to fight inflation. It is the Fed's role to take away the punchbowl when excesses are created in the economy. Over the past decade, the Fed has lost focus of its mission, blinded by misunderstood dynamics introduced by the internet and globalization. Let us examine why the Fed is shifting its focus to growth.

For the Fed to shift its focus away from fighting inflation, it must either believe inflation is not a threat; or it must think that the risks posed by a slowdown outweigh the risks posed by inflation. As to the former, the Fed clearly states that "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." That statement alone would require the Fed to tighten monetary policy further as a pre-emptive insurance to fight inflation. This means the Fed is clearly concerned that the risks of a slowdown outweigh the risks posed by inflation.

But why would a slowdown be something the Fed should be concerned about? The only reason the Fed would try to prevent an economic slowdown is if it were concerned it could spiral out of control. And that's the core of the matter: in our assessment, Fed Chairman Ben Bernanke is concerned we could enter a deflationary spiral akin to what Japan experienced. How could such a deflationary spiral come about? You start with a credit bubble, with a consumer loaded up to their teeth with debt. In a credit crunch, the consumer would be forced to reign in his or her spending to service the debt; given that about 70% of the U.S. economy is comprised of consumer spending, we are talking about a severe recession or possibly a depression to force consumers to become savers rather than spenders.

Why would such a credit crunch come about? A credit crunch follows a credit bubble; the Fed and the Administration contributed to the creation of a credit bubble through excessively accommodating monetary and fiscal policies (low interest rates and low taxes). The environment lead to consumers taking on excessive credit; the money that was created has helped push up the prices of everything that we cannot import from Asia, from home prices to the cost of education, healthcare and local craftsmen. Up until a little over a year ago, the preferred source of money creation by consumers was to extract equity out of rising home values. Over the past year, record low volatility in most asset classes encouraged speculators to increase their leverage, thereby further increasing money supply. Suddenly, volatility is back to the markets, just as the weakest link of the housing sector, the "sub-prime" market, is breaking down. Note that the volatility of recent weeks is closer to normal, not the quiet markets of 2006. If this volatility persists, or if the fallout from the housing market spreads, we may be in for a serious credit crunch. Those who hope that the trouble in the mortgage sector is contained to the "sub-prime" end of the market are likely to be ill prepared for what may lie ahead. Aggressive lending practices that have lasted years are threatening housing prices nationwide, including those neighborhoods that are "different" because they only have affluent homeowners. A home price correction of 5% is not the hallmark of the bottom of a burst bubble, even if politicians are already calling for the rescue of those irresponsible homebuyers who bought homes they never should have afforded. Where were these politicians when these risky loans were sold? They tacitly endorsed the lending practices because home prices were rising, benefiting "everyone", except those who had to take on even greater debt to buy a home.

In numerous speeches in recent weeks, the Fed has been trying to convince the markets that it is just normal for inflation to peak after the economy peaks. The problem, of course, is if inflation does not abate as the economy slows down, i.e. if we enter a 1970s period of stagflation. We believe that fighting a credit contraction induced by market forces through stimulative policies will lead us to such a stagflationary environment; the Fed seems to hope that the forces of globalization will keep inflation statistics at bay. The Fed's "increased transparency" is nothing but increased expectations management. The Fed's role is not to manage expectations, but to manage fundamentals; the mere fact that expectations are ever more important shows that something is wrong with the fundamentals.

For further analysis why the Fed is concerned about growth, please also see our more detailed discussion of the potential fallout from credit derivatives; as well as our discussion of how the Fed has lost control of money supply.

The Fed is scared about what may lie ahead, and as a result is fighting the risk of a credit and liquidity crunch. We are afraid that printing money when market forces suggest a recession is overdue may have dire consequences. The rise of gold and the fall of the dollar are issuing strong warning signals that the Fed is veering into uncharted territory, a territory that would be labeled off limits if it were on a ski slope. The slippery slope entered may cause havoc in asset prices ranging from equities to fixed income to real estate. When money supply is increased, this money will flow somewhere; we are afraid that sooner rather than later, it will foremost push up inflation. The Fed may think that it knows how to fight inflation should it become a serious issue; but the further we press on with growth at any cost, the cost of correcting the course becomes ever greater.

Investors interested in taking some chips off the table to prepare for potential turbulence in the financial markets may want to evaluate whether gold or a basket of hard currencies are suitable ways to add diversification to their portfolios. We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.