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By Jason Stipp | 11-11-2010 02:04 PM

Merk: Don't Fight the Fed

If the Fed wants to have a weaker dollar, investors should do what central banks do: diversify to a basket of currencies, says Merk Funds Axel Merk.

Jason Stipp: I'm Jason Stipp for Morningstar.

The dollar has been popping up in a lot of market headlines recently, especially in light of the Fed's recent policy action. But what does this currency news mean for investors? I'm joined today with Axel Merk of Merk Mutual Funds and also a currency expert. He is here to offer his insights on the situation.

Thanks, for calling in today, Axel.

Axel Merk: My pleasure.

Stipp: First question for you: The Fed, obviously, had its reasons for the additional $600 billion of stimulus. You wrote in a report recently that there is likely to be several unintended consequences from the Fed's actions. Can you outline some of those effects and what they may mean?

Merk: Yes, by all means, and maybe they're not even unintended. We believe that the Federal Reserve may be squarely targeting a debasement of the U.S. dollar. Fed Chairman Bernanke has talked about how going off the gold standard during the Great Depression has helped the U.S. recover from the Great Depression. He has said that a weaker dollar is not inflationary. We disagree with that, but that's his view. Then he is putting actions into his words by buying government bonds. These securities are now intentionally overvalued, rational investors may look overseas for less manipulated returns. And so that's the premise that we have, that he may be acting to get a weaker dollar.

Now, the unintended consequence, maybe, is that Bernanke is completely underestimating the political dimension. The fallout that we have--particularly overseas fallout. Let's remember that during the Great Depression, what got the Great Depression really to be so horrible was the trade war that started, protectionism flared up, all unintended consequences of well-intended policies that served the home market, but completely underestimating the global implications of these policies.

Stipp: Certainly we've seen a lot of headlines since that policy announcement, reactions from different world leaders. It sounds like you think that's more than just talk, that we could see some actual policy responses from the international community that could lead to some problems on the trade front?

Merk: Well, let's keep two things in mind. Every country, the U.S., China, anybody will always do what they perceive to be in their national interest. I say perceive because sometimes they don't know what's in their own good. And the other thing we do know is that many parts of the world, including much of Asia, has imported U.S. monetary policy by pegging their currency to the U.S. dollar.

So, when the Federal Reserve debases or tries to debase the dollar by engaging in quantitative easing, it's as if the Federal Reserve puts a gun on the chest of China to say, now you've got to act. You need to allow their currency to appreciate. The reason why China needs to do that is because inflationary pressures cannot be controlled using administrative tools. We've seen it with the most recent news come out yet again, when inflation is flaring up in China that most effective way for Asian countries to tame those pressures is by allowing the currency to appreciate.

And these countries don't like it because they are uncomfortable with it. Now, what we're arguing is that the countries that have more advanced economies, such as China or even the Eurozone going in this direction, they have pricing power. At the other end of the spectrum, countries like Vietnam that can't compete on price, they will engage in competitive devaluation. But for the time being, there is a lot of anger out there in the world because the U.S. conducts these things unilaterally, and of course, they do because they act in their own self-interest, but the communication the U.S. has done to encourage other folks to cooperate with the U.S. has not been very effective.

Stipp: So Axel, as an investor, and looking at the fundamentals of currencies, what do you think the impact then is going to be longer term for currencies? And which currencies do you expect to move over the longer term because of some of these factors that are coming into the marketplace in the U.S. policy?

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