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Dollar may rise even as U.S. economy weakens, research firm says

Section: Daily Dispatches

Dollar may gain even with US hard landing: Lombard

By Steven C. Johnson
Friday, December 8, 2006

NEW YORK -- The dollar will rise in 2007 even as the U.S. economy slows sharply, a top U.K. research firm said on Friday, as Asian central banks continue buying greenbacks to keep their currencies down and their exports competitive.

A housing slump in the United States will finally cause Americans to cut back on spending, while rising labor costs will prevent the Federal Reserve from cutting interest rates until the second half of the year, said Diana Choyleva, director at Lombard Street, a London-based research firm.

But she said Asian states with large surpluses and export-driven economies will still need to recycle savings into U.S. assets and keep their currencies from rising too rapidly against the dollar.

And with Americans saving more, "the supply of dollars will shrink at a time when demand for the dollar will be going up," Choyleva said at a conference in New York, and that will put upward pressure on the dollar.

The outlook runs counter to a widespread FX market view that the dollar will weaken in 2007 amid slower U.S. growth and an expected decline in U.S. interest rates.

Choyleva said markets are pricing in a rate cut too soon.

"There's a big chance growth will be high enough in the near-term to exacerbate the inflation outlook than low enough to help with inflation," she said, adding, "The Fed will need to engineer a hard landing to get inflation back on target."

U.S. consumer spending will fall, though, as home prices continue to slide. The National Association of Realtors reported last week that existing home prices fell 3.5 percent in October for the third straight month.

Rapid gains in home prices had been the main driver in recent years of U.S. consumption, which comprises some two-thirds of U.S. gross domestic product.

The result over the next 12 months to 24 months, she said, will be a gradual unraveling of global financial imbalances caused by excessive American spending and excessive saving in Asia.

And even if the U.S. spending spree ends, Asian states have assets to spare, said Brian Reading, head of Lombard Street's world service. That's especially true of China, with a stash of foreign exchange reserves that recently topped $1 trillion.

Chipping away at imbalances is a top priority of the U.S. Treasury Department, too, though its preferred method is for China's yuan to rise against the dollar, making Chinese imports more costly to U.S. consumers and boosting Chinese demand.

The only Asian currency likely to rise against the dollar in 2007 is the yen, Reading added, as Japan is one of the few Asian countries with rising domestic demand.

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