Thursday, November 01, 2007

Fed Rate Cuts Imperil the Dollar

The Federal Reserve is on a mission. By slashing interest rates, you may get the impression the Fed is out to save the economy. Instead, it is trashing the dollar.

It now costs almost $1.45 to buy one euro. It costs $2.08 to buy a British pound. Gold is $800 per ounce, and oil, which is denominated in dollars, costs more than $95 per barrel. There seems little doubt that we will soon break the dreaded $100 mark. One hundred dollars is exactly the price Osama bin Laden suggested the West should be paying for a barrel of oil soon after he attacked America on Sept. 11, 2001.

Investors, however, are cheering as the Fed devalues our currency. The Dow rallied 138 points in response to the latest interest rate cuts. The Fed reduced the discount rate by a quarter point to 5%. At the same time, it reduced the fed funds rate by a quarter point to 4.5%. With oil and gold prices near record levels, you might think that reasonable people would expect stocks to be struggling a bit. Reason, however, seems to be in short supply on Wall Street.

The Fed justified its latest rate cut by saying that economic expansion is likely to slow in part due to the housing correction. Furthermore, it said core inflation readings have improved. Apparently, no one at the Fed drives a car, buys food, or heats his home.

Those who have mortgages that are about to adjust to higher levels might want to send the Fed a thank you card. The Fed has given them an opportunity to switch into fixed-rate loans. Unless significant penalties are involved, refinancing in this manner should payoff over the long term.

The Fed’s action came the same day the Department of Commerce released its advance estimate for third quarter GDP. Although the figure is subject to revision, growth was a much stronger-than-expected 3.9%. It is no surprise that exports contributed to this growth. They surged 16.2% because the weak dollar makes American goods cheap abroad.

With growth near 4% it seems odd that the Fed would risk inflation by cutting interest rates. Core inflation may be tame, but headline inflation is not. The Fed is obviously looking ahead, and apparently it does not like what it sees. It may be worried that the sub-prime mortgage mess has not fully settled. It may also be concerned that consumer spending will eventually take a hit. Consumers, however, are weathering the housing bust and high oil prices fairly well.

But consumers don’t buy crude oil. They buy gasoline and heating oil. Despite high crude prices, gasoline prices have remained well off their spring highs. But how much longer can that last? Either gasoline prices must rise, or oil prices must fall. Gasoline inventories may fall in coming weeks as refiners start producing more heating oil. And with Thanksgiving just around the corner, demand for gasoline is likely to rise. Don’t be surprised if gasoline prices surge 20 to 30 cents per gallon by the end of this month.