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As Dollar Tumbles, Should Fed Stop Cutting Rates?

Thursday, 6 Mar 2008 | 12:55 PM ET

The dollar is tanking. Oil and other commodity prices are at record highs. And many economists blame the Federal Reserve's aggressive interest-rate cuts for the problem.

The Fed is cutting rates to bolster the slumping economy and keep the credit crunch from getting worse. But in the process, the central bank is creating other problems--including the potential for higher inflation. A weak dollar tends to boost oil and other commodity prices and makes imports more expensive for Americans.

That brings up the question: Should the Fed stop cutting interest rates?

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Economists say the Fed probably underestimated the impact of lower interest rates on the dollar, crude oil and gold. Still, they believe there is little chance the central bank will try to reverse market trends by keeping interest rates on hold when it meets again in two weeks. Even so, the Fed might decide to refrain from further rate cuts after that.

The dollar was already slumping and crude and gold prices were on the rise when the Fed began trimming interest rates last August. But trading momentum accelerated significantly after the central bank slashed its target federal funds rate by one and a quarter points in late January, to 3 percent.

“They should have anticipated that, the message has been on the table," says Ram Bhagavatula, an economist and managing director at the hedge fund Combinatorics Capital. “At this point, I don’t think they can afford to stop. They’ve sort of committed themselves to saving the financial sector, housing, the economy from recession."

As usual, what people think the Fed should do and what it actually does are two different issues. Nevertheless, both supporters and critics of the Ben Bernanke Fed are in agreement over both the Fed’s next policy move as well as the quandary it is in.

Robert Brusca of Fact And Opinion Economics has been worried for some time about the inflationary risks of the Fed’s aggressive rate cutting. But he says Fed policymakers are wedded to battling the recession-credit crunch combination and aren't about to take on another fight at this point.

“I think the Fed has a pragmatic view, a triage view, so to speak," Brusca says. "First, they're trying to save the economy. If you have a recession, and real estate gets worse, bank lending will tighten."

Federal Reserve Bank Chairman Ben Bernanke
AP
Federal Reserve Bank Chairman Ben Bernanke

In other words, a chain reaction would be triggered and the economy could spin into uncharted territory. In this context, for Brusca and others, a weak dollar and high oil prices are the lesser of two evils as well as known evils.

Brusca expects the Fed to cut rates March 18 and might even continue to do so until it sees that the “economy has stabilized.”

Jim Awad, chairman of WP Stewart Asset Management, thinks the Fed will and should cut rates another half a percent at the next FOMC meeting, because the financial sector continues to worsen. But he thinks the easing should stop there.

“The Fed should be loud and clear, strongly telegraph this is it," says Awad. “After that there is no additional net benefit from rate cuts.”

Awad is worried about containing an outbreak in inflation. So is Bahavgatula who says there is a good possibility of 1 percent growth and 4 percent inflation at the core rate in six months time.

Bhagavatula is not shy about saying the Fed “overdid it in the first place,” in cutting rates so aggressively. “Commodities would be lower, the dollar would be stronger,” he says.

Brusca is neither worried about the market moves nor the Fed’s appreciation of the dynamic. “Exchange rates will be pushed to an excessive level and something will give. The same thing applies to commodities,” he says. "They have to be seen by the Fed as excessive, and something will give.”

Awad suspects the Fed may have been somewhat surprised by the dollar-oil moves. Such moves, he says, “may have been hard to predict” but attention must be paid to them because “they are dangerous momentum trades.”

“The best way to break it is to stop cutting rates,” says Awad.

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