How the FOMC Interest Rate Meeting Will Impact US Dollar

By: Money_and_Markets

Jack Crooks writes: The Federal Open Market Committee (FOMC) meets this week. As you might imagine, a lively topic of conversation this weekend among currency traders is the direction of the infamous Fed Funds rate.

The obvious question leading up to Tuesday's interest rate decision: What are the implications of this FOMC meeting on the U.S. dollar? More specifically, has the Fed Funds rate found a bottom, or does the U.S. central bank have more work to do?

Today, we'll explore the Fed Funds rate argument from the perspective of both dollar pessimists and enthusiasts, giving each camp equal due.

In light of the fact that the University of Michigan/Reuters Consumer Sentiment Index just plunged to a 26-year low, let's give the gloomers and doomers their say first ...

Dollar pessimists believe there is STILL no positive argument in favor of the U.S. economy.

The Federal Reserve's dual mandate — maintaining economic growth and price stability — has become quite a flash point in currency circles. Much of the dollar's demise has been attributed to the Fed's obligation to buoy growth even when inflation isn't necessarily contained.

And keeping the U.S. economy above water hasn't been an easy task for them. I've consistently checked-off a myriad of soft spots that are catching up with the economy and infecting the core.

Federal Reserve Chairman Ben Bernanke continues to face intense scrutiny ahead of Tuesday's FOMC meeting.

Among them are ...

• An unstable manufacturing sector;
• Deteriorating business conditions;
• Sluggish consumer spending;
• Serious slack in the labor market; and
• A widespread feeling that money isn't so easy to come by anymore.

And almost certainly, all of the aforementioned troubles have been initiated or exacerbated by the ongoing U.S. housing market collapse.

I'm not going to drag you though all of the painful details right now because, for all I know, you're getting bored with every new housing-related disappointment you hear about.

Suffice it to say, the impact of the housing debacle on U.S. consumers has been swift, sudden, and severe. This in turn has, and will persist in creating major headaches for the financial sector. American Express told analysts yesterday that financially stressed consumers are making fewer payments less often.

As a result, dollar pessimists believe the U.S. economy will continue to falter, giving the Federal Reserve no choice BUT to cut interest rates even further.

I have to admit; they do have a point. After all, the FOMC has sliced an unprecedented 300 basis points off the Fed Funds rate since their September monetary policy meeting.

On the other hand ...

Dollar optimists believe intense commodity inflation will FORCE an adjustment to Fed policy.

The Fed's dual mandate has left them somewhat handcuffed to a sinking economy. But at least they sometimes recognize that inflation risks exist. But the fear of inflation and inflation are two different animals. The Fed has the fun job of keeping both beasts under control.

Can you imagine what's going through their heads right now? Crude oil topped $119 a barrel this week. But beyond the heavily monitored energy prices, food has stepped right up into the media spotlight.

Dollar enthusiasts are betting that soaring commodity inflation will ultimately force the FOMC to revaluate its monetary policy.

Riots have broken out in Haiti because of food shortages. A handful of countries that include China and India have pulled back on their rice exports in order to sufficiently meet domestic demand. And we even learned this week that two popular U.S. wholesalers (Sam's Club and Costco) are monitoring the amount of bulk rice purchases they allow customers to make.

Dollar optimists believe that runaway inflation on commodities will ultimately warrant some kind of adjustment to Fed policy. Consequently, this would be good news for the greenback.

Why? Few analysts will argue that the Federal Reserve needs to hike interest rates. But the possibility that the fed may halt its easing campaign is growing among analysts.

And perhaps that's JUST what the doctor ordered.

A monetary policy revaluation could spark a legitimate dollar rally!

If Fed Chairman Ben Bernanke and Co. were to carve out a bottom-turn in their easing campaign, it just might give buyers enough reason to come out in support of the dollar.

And a legitimate dollar rally would likely impact commodities, considering the extreme negative correlation that's existed between the two parties.

Fed Watch: Given the way things stand, I'd say ...

If you're looking for some currency specific advice heading into Tuesday's FOMC meeting, have a look at the following chart of the U.S. dollar index. It may offer up some guidance.

Each of the red numbered arrows reflects the size of Fed interest rate cuts in the last six monetary policy decisions. Each box encapsulates those trading days surrounding the decision.

Given the way things stand, I'd say a rate cut of 25 basis points or fewer likely won't kick off an extended dollar decline. And if the Fed does opt out of rate cuts this time around, it would be a huge departure from expectations leading up to the decision.

That, of course, could kick off a sharp dollar rally.

Best wishes,

Jack

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