"Statistically, the pass-through from Dollar declines into US inflation has always been low, and appears to have fallen to near negligible levels in recent years," said Goldman’s Robin Brooks in a note today. "This means that the Dollar needs to fall a lot further – even after recent declines – to contribute to raising inflation towards the Fed’s desired level."
The Fed is expected to start a second round of quantitative easing next week by beginning a series of Treasury purchases that should ultimately total anywhere from $500 billion to $1 trillion, investors said.
The purchases will expand the Fed’s balance sheet (printing money) and weaken the dollar. A weaker currency stokes inflation by making the real price of goods and services here more expensive. In this case, Fed Chairman Ben Bernanke wants to spark some of the so-called good inflation, in order to get the economy moving again and to avoid dastardly deflation. With his benchmark rate already at zero, it may be a lot harder to do than he thinks.
"Substantial additional monetary stimulus is needed for the Fed to meet its dual mandate on inflation and employment," wrote Brooks, who last week raised her estimate for the total size of QE part two to $2 trillion from $1 trillion. "If indeed the Fed sees the Dollar as one of its key policy levers for preventing inflation from staying below its mandate for a prolonged period – the dollar needs to fall a lot further from here."
To come to her conclusion, the analyst used past research from the Fed and her own models to test how much the dollar must decline to significantly boost inflation. Even when using extreme examples, such as assuming China would pass on 100 percent of its increased currency cost to U.S. consumers, the impact on the consumer price index was small.
Over the last three months, a drop in the dollar boosted stocks in an almost perfect inverse correlation, as investors bet a weaker currency would help multinational earnings overseas by making their goods cheaper. Brooks’ note may explain the breakdown of that relationship today.
"The trick for the FOMC is to orchestrate an orderly decline in the US Dollar to create inflation and monetize our debt," said Joe Terranova, chief market strategist for Virtus Investment Partners and a ‘Fast Money’ trader. "The risk and difficult task will be avoiding a rapid, disorderly decline. If the capital markets should fear anything, it should be a fast selloff in the US Dollar."
Goldman’s base case is for a "five percent decline in the Dollar on a broad, trade-weighted basis from here over the next 12 months."
The question is, when Bernanke discovers he’s shooting blanks, how much further could the currency fall?
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John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team