Fed’s Post-War Visibility Likely to Remain Cloudy by Leeanne Su
May 5, 2003 (FOREX News)
ME: key quote near end provided for you
the Fed is caught now in a box, which I described last summer
they cannot lower rates, they cannot raise rates
they can only watch in horror as the USDollar collapses!!!
Regardless of the Fed's assessment, the dollar's doldrums are unlikely to be reversed. Yet more sell-off could ensue in the event that the central bank does cut rates. Even a fresh easing directive (easing bias) from the FOMC would communicate to investors the weak state of the US economy and a lack of confidence in the ability of the economy to walk on its own, thereby hurting the currency.
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The monetary policy committees at the Federal Reserve, the European Central Bank, and the Bank of England are convening this week to make an interest rate decision for the first time since the conclusion of the war in Iraq. Geopolitical fears stemming from the Iraq conflict were incessantly used as the scapegoat for the cloud of uncertainty hanging over the world’s economies. But now that the war has ended, the economic forecasts have yet to see clearer skies.
The overall consensus, or rather hope, is that the sputtering recovery will accelerate in the second half of the year. Yet before central banks entertain the notion of a revitalized world economy, they must consider whether to grant one last round of monetary easing to insure their economies receive the optimal dosage for a healthy recovery.
The Fed's Dwindling Ammunition
The Federal Open Market Committee leads the pack with its meeting on Tuesday while the ECB and BoE are scheduled to announce their decisions on Thursday. In his close-scrutinized testimony before the House Financial Services Committee last week, Chairman Alan Greenspan conveyed a cautious view of the economy. He offered assurances that higher growth lies ahead yet remained elusive on the exact timing. Mr. Greenspan also expressed guarded support for President Bush's tax plan, stressing that fiscal stimulus would be effective only if it does not exacerbate the budget deficit and is accompanied by spending cuts. The Fed Chairman warned that growing deficits are likely to induce higher market rates, which in turn could force the Fed to prematurely tighten interest rates.
Known amid the staunchest growth supporters among the major central banks, the Fed now faces a limited amount of maneuvering room when it comes to interest rates and could be reluctant to cut rates further unless conditions deteriorate perceptibly. Nonetheless, post-war economic data can be characterized as mixed at best. The manufacturing sector witnessed the second consecutive contraction in April, as measured by the Institute for Supply Management’s manufacturing survey. First quarter growth also disappointed expectations, rising 1.6% instead of the anticipated 2.3%. Adding to the gloom, last Friday’s labor report reaffirmed the stagnancy in the labor market. Payrolls fell another 48,000, recording the third consecutive monthly decline. The headline unemployment rate ballooned to 6.0% from 5.8%, the worst since December 2002.
The buoyant gains rebound in US stocks during the earnings season have perhaps given consumers and policymakers a false sense of security. While first quarter earnings generally surprised to the upside, many companies had scaled back their forecasts ahead of the reports. Moreover, the brunt of the improvement in profit margins was underpinned by aggressive cost cutting measures such as slashing payrolls -- hardly a recipe for a broad-based recovery. It turns out that the "productivity miracle" much touted by the Fed Chairman could now work to the detriment of the labor recovery.
Another notable phenomenon observed from the earnings reports was the largely favorable impact of the weak dollar on US multinational’s bottom line. But until business increasing sees a steady rebound, a crucial driver of the economy will remain absent. Admittedly, however, a sustained rise in share prices could encourage companies to increase spending.
The FOMC could decide to maintain a wait-and-see stance and refrain from issuing a balance of risks assessment for the second time, but the economic and geopolitical uncertainty excuse is starting to wear thin, and one has to question whether the Fed can afford to wait for more data. With the broad US equity indices up more than 15% and today’s release of the ISM services survey’s rebound above the key 50 level, the Fed will likely vote to keep the fed funds rate unchanged at 1.25%, and reiterate its neutral policy directive after refusing to issue its assessment on the balance of risks at the March meeting. But a quarter point cut could well come this summer in the event that economic sluggishness escalates throughout the corporate and consumer sectors.
The Implication for Exchange Rates
The dollar’s war rally quickly faded as traders diverted their attention to the US economy. Not only are growth concerns battering the greenback, but also the search for yields has become fashionable again. In illustration of this phenomenon, commodity currencies with advantageous yields such as the Canadian dollar and the Aussie have rallied to multi-year highs against versus the greenback.
The other frequently cited rationale for the dollar's demise is the reemergence of the twin deficits. Dollar bears have long warned that the corpulent current account deficit as a disaster waiting to occur for years. The current account stands over 5% of the nation's GDP, which requires enormous foreign capital inflows into dollar-denominated assets to sustain the deficit. But capital flows into the US are showing signs of deceleration as investors transfer their money to higher-yielding assets in other countries.
The euro has reaped most of the windfall from the dollar's sharp decline since export-dependent Asian countries remain keen in averting a rise in their currencies, as evidenced by the Bank of Japan's covert intervention operations earlier this year. Notably, Bundesbank Vice President Stark admitted in an interview that he would not be surprised to see euro rise to as high as $1.30.
Regardless of the Fed's assessment, the dollar's doldrums are unlikely to be reversed. Yet more sell-off could ensue in the event that the central bank does cut rates. Even a fresh easing directive (easing bias) from the FOMC would communicate to investors the weak state of the US economy and a lack of confidence in the ability of the economy to walk on its own, thereby hurting the currency. Sterling's fall was partly the result of such sentiments following the BoE's 25 basis point cut. Moreover, a Fed easing action would further trim the yields on US fixed income assets and reinforce global investors' flight to better yields elsewhere. |
