The Federal Reserve Needs to Pause

April 29, 2008

No one wants to be in the shoes of the Federal Reserve today as they begin their 2 day monetary policy meeting. Fed officials face a tough decision as they weigh the risk of deteriorating growth with the risk of rising inflation.

Unfortunately for the Fed, the problems with growth and inflation have only escalated in recent weeks. The US economy shed jobs for 3 consecutive months and job losses will continue into the month of April. We are in a recession and it be just a matter of time before the US central bank admits it.

As indicated by the tables at the end of this article, the housing market and the labor market has deteriorated since the last Fed meeting. The only dollar positive news are the increased inflation pressures and mild improvement in manufacturing sector activity. However despite the rise in service and manufacturing ISM - they both remain in contractionary territory, which is not dollar positive.

Federal Reserve Needs the Dollar to Rise

At this point the Federal Reserve’s options are limited since they cannot raise interest rates to combat inflation. One of their only options is to let the dollar rise. The strength of the Euro has helped the Eurozone fend off inflationary pressures while the weakness of the US dollar has only exacerbated them. To cut interest rates by 25bp (rate cut expectations) and then signal that they will pause in June would be a simple gesture by the Fed that could bring significant benefits. Traders would assume that the Fed’s rate cuts are over, at least for the time being and as result, they may send the Euro back down towards 1.50 and USD/JPY back above 105. This takes away some of the benefits for US exporters, but it could help curb inflationary pressures.

To Pause Does Not Mean to Stop Cutting Interest Rates

Postponing any additional easing after their anticipated quarter point rate cut on Wednesday will not mean that the Fed has put an end to their easing cycle. They are just giving the market an opportunity to absorb the 325bp of rate cuts that they have will have doled out since August and any temporary boost from tax rebates. If the economy does not respond, then they could easily pick up where they left off. Right now, they need to buy themselves some time by forestalling further inflationary pressures.

The US Economy Will Continue to Weaken

Although a pause from the Fed would be perceived as dollar positive, I continue to believe that the US economy will deteriorate further. Job losses will extend not only for another month, but for at least the next 3 or 4 months (chart of previous NFP losses).

Over the past 3 decades, the US economy has gone through 3 recessions. During these contractions, there were a string of job losses that lasted for a minimum of 10 months. We are already beginning to see this trend unfold. It will be months before we will see the economy start adding jobs once again. The largest single month job loss in each of the recessions was more than 300k. I wouldn’t be surprise to see the same degree of job losses in this business cycle.

Where the dollar is headed against the Euro is more complicated because it all depends upon who gives the market a bigger surprise. Weak US growth has pretty much been priced into the dollar and everyone is waiting for signs of an improvement. Whereas for the Eurozone, traders are waiting for signs of further deterioration.

Posted in Fed Rate Cut, Fed Rate Cut Expectations, Federal Reserve