Be careful what you wish for. The US equity market has responded positively to the Federal Reserve’s 50 basis-point reduction in the Federal funds rate, primarily because it senses that the Fed now “get’s it” in terms of the risk to the economy posed by the severe credit contraction in recent weeks. The market simply did not broadly agree with the Fed’s assertion of early August that the predominant risk to the economy going forward was inflation. Note, however, that the Fed continued to cite the reality of the inflation threat even as it cut rates boldly in an effort to head-off a downward spiral of market and consumer psychology.
The question now shifts to whether the equity market “get’s it” in terms of the risks to the economy going forward posed by one of the most prominent “side-effects” of the Fed’s dose of anti-depressant interest rate cuts — namely, the continued spiral down of the US dollar’s relative value in the global currency markets.
In the short run, the dollar’s decline has shown a positive effect in terms of helping to reduce the huge US trade deficit caused by our importing more than we can pay for out-of-pocket (which has led us to borrow heavily from the dollar accumulations in the hands of those economies that export the most to us like China and the oil economies of the Middle East). This recycling of “petro-dollars” and “Wal-mart dollars” is nature’s way of imposing a balance, and it has overall had the effect of restraining inflationary pressures in the US to some extent. Moreover, it is at least arguable that, if the Fed’s interest rate cut and possible further cuts helps secure a soft-landing and quick bounceback for the US economy, the dollar should strengthen and the global recycling machine will be up and humming again.
But in any imbalance, there can come a “tipping point”, and the reaction to the Fed’s move in the currency markets may be bringing us closer to one which could reverse the so-far positive consequences of the lower dollar for the US economy.
Not surprisingly, the fulcrum for that tipping point could well be oil. That commodity, like many others, is priced in US dollars, and those who sell it like the Saudis have tended to manage their domestic currencies with an either explicit or implit linkage to the American currency to smooth out potential gyrations in their own economies.
Perhaps it has not been sufficiently noted, however, that the Saudis did not make an equivalent adjustment to their interest rates after the Fed made its cut this past Tuesday. Could this be a signal that the Arabs are running out of patience with pricing oil in dollars as the Euro continues to move toward more promise as a medium of exchange (not that there is anything else going on in their neck of the woods that might trouble the Arabs about US behavior and interests)?
Imagine a world in which a new “gas tax” was added to the price at the pump for US drivers — namely, the currency exchange premium necessary to convert US dollars into Euros just to buy the oil in the first place. While this might thrill the hearts of those concerned with global warming, it could also lead to a myocardial infarction in US economy with a renewed risk of inflation due to escaling prices of all commodities priced in dollars, and a subsequent slowdown in GDP growth that would make the housing credit crunch feel like minor heartburn by comparison.
The Fed may have had no choice but to take the action it did to stave off the more immediate threat of a psychological melt-down among US consumers (or, at least, among equity fund managers). But in kicking the dollar can down the road, the Fed may have scored an “own-goal” for the inflation team, and it will need a partner or two to help manage the currency consequences of its action. Look for Treasury Secretary Paulson to make one of those famous Treasury-Secretary “we support a strong dollar” speeches one of these days soon.