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Thursday May 1, 2008 - 13:28:25 GMT
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Forex Blog - Fed Motor Car Pulls Off Easy Highway

Despite an attempt to deliver a clear signal of a pause in policy easing after 325bps of accommodation and a host of unprecedented liquidity measures, the FOMC still has a terrible hand…recession and rising price level (including, and in part fanned by, a falling dollar).  Simply all the Fed could do was flip the indicator signal and pull off the highway of easing for who knows what…potentially and end to the journey (I think unlikely), a 14-week nap (little more likely) or an 8-week rest/refuel (more likely than end to easing cycle).  Part of the Fed’s predicament is due to the very nature of the problem…the banking system is still deeply dysfunctional and normal monetary policy transmission channels through the banking system are not open.  So cutting more is pushing on a string and in terms of prices more like pushing on a spring (price transmission channels are fully open). 


I would also not underestimate the role the eight week break between FOMC meetings played in the Fed’s decision to wink at markets (as opposed to a nod) looking for confirmation of an end to the easing cycle…there is not as much at stake saying policy is on hold when the next planned meeting to decide rates is not until June24-25 (and I believe a Humphrey Hawkins testimony in between).  If the data continues to deteriorate, prices cool some and the Fed decides June25 to cut again, it will feel like a pause even though none has happened.  And if nothing else Wednesday’s subliminal message on rates will help check dollar downside.  That said markets priced the pause ahead of the meeting and it was not surprising to see the dollar unwind some of the recent gains after the news. 


My concern is that the Fed pulled off the highway to refuel and will get back on the easing highway as despite all its deficiencies, cutting Funds rate is the only road outta here and we are early in the economic pile up.  I would be far more confident of a lasting Fed pause if Washington was more involved in stabilizing the housing market and that vehicle looks like it is in need of road assistance.


Few words on Q1 GDP – it was a stinker.  Do not lose sight of the forest for the trees as media and econologues (Brian Westbury’s of the world where balanced economics is replaced with a dogmatic political economy agenda) seems to – as long as we do not have back-to-back quarters of contraction in GDP we are not in recession and everything is okay.  For the seven quarters (starting Q1 2006) GDP averaged 2.8% SAAR and since Q4 2007 GDP is averaging 0.6%...that is 2.2% wiped off the economy.  Anyone who does not think this is a recession needs a lobotomy.  Also all the indications from the domestic economy including business investment (on top of slower consumption, housing investment contraction of unprecedented magnitude and weak inventories) point to a serious recession.  Okay net exports are a big offset and without them GDP would have been negative in Q1.  But what is the outlook for net exports even with a weak dollar?  Well with monetary policy tightening in Europe (credit conditions if not official rates), Latin America (including Brazil) and Asia (including India and China), the export safety net is not sustainable.  Japan and Europe are showing early signs of what emerged in the US in Q4.  Get a grip Mr Westbury (Dr Pangloss) – 0.6% could easily be revised to -1.6% - margin of error is +/- 1% point.  I think it is safe to attribute more downside risk to GDP revision than upside ahead. 


On the dollar – I was early to call bottom in dollar, embraced lower dollar on break of 1.49 triple top and no running risk of being late to again embracing the dollar bottom.  I said in a recent email that I have 3 conditions for a dollar turn – 1/ Fed signals an end to easing (40% weight), 2/ ECB introduces two-way risk in interest rates (40% weight) and 3/ joint currency intervention (20% weight).  Where are we?  About half of condition 1/, zero on condition 2/ and 3/.  So the die is not yet cast despite the gushing from the tube and the pages of Barrons.  It is also worth noting that sterling, C$ and A$ are starting to diverge from the euro’s performance versus the dollar and these currencies were the first to turn lower in the overall dollar downtrend – for many the canaries in the coal mine in terms of the dollar.  Arguably the recent strength in the Anglo Saxon currencies against the dollar may be telling us that the dollar is correcting, not reversing its long-term trend lower which would be consistent with my current read on the 3 conditions for a trend change in the buck 


David Gilmore


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