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Forex Blog - Fed Tightening Assumption Points at Parallel Universe

It does not take special powers or an Ivy League education to realize the Fed does not always get the economy or monetary policy right.  Greenspan holding rates at 1% for far too long and ignoring warning signs from colleagues and market participants of the housing bubble filled with easy-credit helium was unsustainable comes to mind.  So too does Bernanke’s and the Fed’s assertions of a year ago that housing prices would soon bottom and the subprime problem was contained. 

So why are so many in the market certain the Fed is going to hike rates at the first opportunity?  First the Fed had an opportunity to hike at the end of June and took a pass – while not widely expected at the time capital markets were relatively tranquil (pre GSE meltdown) and the equity market could have absorbed a tightening without cratering. 

But conditions have deteriorated since then with the GSE backstopped before they could fail and stocks having a heck of a time putting in the bounce in a proverbial bear market. 

But for the Fed to hike, one has to believe that inflation can thrive in a world of not just weak growth, but in a protracted global recession.  Look at oil today and in the last few weeks…ignoring Iran’s reckless leadership as it seemed to ignore overtures for diplomacy from the US and broader calls for an end to its nuclear enrichment program.  Yet oil is lower.  A tropical storm is now heading through the Gulf of Mexico toward Houston and could reach hurricane force winds by landfall and oil is down over 3%.  Nigerian rebels are actively sabotaging oil facilities (pipelines) in the oil-rich region and oil prices are lower.  Why?  Well maybe more than a few of us are questioning the Fed’s assumptions about growth and inflation ahead and see rising significant downside risks to growth, not diminishing serious downside risks to growth as noted in the June FOMC statement and minutes.  Europe and Japan look like they will post negative GDP in Q2…for Japan that would be back-to-back contractions.  China’s political leadership has turned the government’s economic priority to supporting growth (because it is slowing) from preventing economic overheating.  Even the PBOC is “asking” banks to increase lending by 5%.  Commodities leaving Brazil and Australia bound for China are beginning to show some moderation.  If you know Jefferey Dalmer is hanging around your neighbor’s kids, do you wait for Mr. Dalmer to start the barbeque grill before alerting the police and the parents? 

There is no way the Fed can say what it did in the June statement and minutes – inflation risks are increasing and risks to growth decreasing, while most FOMC members favored a rate hike when conditions allowed. 

Why tighten when credit conditions are as tight as they were when Fed funds traded at 5.25% a year ago?  Why tighten when oil prices are down about $25 a barrel from the record high and levels seen at the June FOMC meeting?  And who believes that high oil does more to fuel inflation than clobber consumption? 

Perhaps the Fed is less inclined to talk about our universe because the outlook is so dim while droning on about economic conditions in a parallel universe might do the consumer well – it is the Phil Gramm world where economic problems are in the minds only of the public because of naysayers and bad journalism. 

I am not suggesting the Fed should ease rates again.  Indeed the most it can commit to is that it does not see Fed funds coming down more ahead.   But why talk about rate hikes when the US economy is about to do a face plant – led by the consumer?  How does this help stressed households and firms much less Fed credibility with the market? 

So I come back to the dollar…people who talk about a higher dollar as the US economy is some accounting principle of first in first out should be scoffed at.  The US economy has plenty in common with Japan’s economy in the 1990’s.  Sure the US economy is more resilient than Japan’s,.  But this simply means a five year adjustment (stagnation) as opposed to a decade of stagnation (arguably still living with the residuals). 

The dollar has another serious thumping ahead, as do equities and very probably oil…there will be a time again when oil and the dollar move in the same direction.  Yes Europe and Japan are also runners up in the ugly economy contest.  But they are also net creditors…the US Needs their savings to thrive.  In a global recession, I think large deficit currencies (I don’t see Australian deficit financing, despite its large share of GDP as daunting) like the US dollar suffer in what now seems to be an inevitable global recession. 

David Gilmore


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