By Jason Simpkins
Just one day after the U.S. Federal Reserve surprised the global securities markets with its biggest rate cut in nearly 25 years, investors questioned whether the central bank action will do further damage to the downtrodden dollar or give the greenback a new lease on life.
The answer depends largely on how the world's other key central banks respond.
Kara – a former economist at the Bank of England – is predicting four cuts from the British central bank this year, and two from the European Central Bank.
The dollar fell sharply versus the euro and sterling Tuesday, as Federal Reserve policymakers slashed the benchmark Federal Funds Rate by three-quarters of a percentage point. The pilloried greenback slipped to 1.46 versus the European euro, from a monthly high of 1.4363. It plunged against the British pound sterling as well, dropping to 1.962 from a 10-month peak of 1.9336.
The dollar was mixed in late-day trading yesterday (Wednesday). By Money Morning's press time, the greenback had slipped a bit more against the euro, dropping to 1.46090. But it rebounded against the British currency, rising to 1.95770 to the pound.
It's been a rough run for the dollar. The emaciated greenback fell against 14 of the 16 most-actively traded currencies in 2007. That includes a 4.9% decline versus the Japanese yen, and a 10.3% drop against the euro.
So far, only the Bank of Canada has responded to the U.S. rate reduction. It cut its rate by a quarter point Tuesday, as it braced for a U.S. slowdown.
When U.S. central bank policymakers cut interest rates by half a percentage point on Sept. 18 – their first rate reduction in four years – the immediate result was the biggest U.S. stock-market rally in five years, with the Dow Jones Industrial Average soaring nearly 336 points.
But there were two secondary impacts, their effects not as immediate, though in the long run they may be more dramatic: The rate cut fanned inflationary fears, and accelerated the dollar's already-existing decline.
By cutting rates when the dollar was already in a tailspin, many analysts feared that the decline would accelerate, causing inflationary pressures to do the same. That potential is even greater if the United States is cutting rates while other central banks are holding the line or even lifting borrowing costs. The reason: Those currencies become much-more desirable investments, causing investors to sell dollars and buy those other currencies. The effect: The dollar sinks as those other currencies increase in value.
The U.S. central bank cut rates two more times after that initial half-point move in September, each of them smaller, quarter-point reductions. But with Tuesday's three-quarter point rate cut – and sinking stock markets across the globe – foreign central bankers who were willing to stand pat before may have to rethink that stance now, many experts believe.
It's worth taking a closer look at the situations facing the U.S. central bank's two European counterparts.
The Bank of England
In the United Kingdom, the economy faces many of the same challenges as its U.S. counterpart, and many experts believe that its central bank – the Bank of England – may be forced to slash rates next. Britain has an overheated housing market, and inflation still poses a serious threat. But with growth sputtering – the economy probably grew at a pace of only 0.5% in the fourth quarter – a reduction in the bank's 5.5% benchmark interest rate may be unavoidable.
Central bank Governor Mervyn King, said yesterday that this year's inflation rate might match the fastest rate in at least a decade, but still left open the possibility of a rate cut.
"It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the chancellor," King said during a speech in Bristol.
When the annual rate of inflation hits the government-set ceiling of 3%, the governor is required by law to write a letter of explanation to the finance minister. In December, that rate hit 2.1%. Given that King is already practicing his penmanship, a rate reduction seems likely. Even so, the U.K. central bank has no plans to advance its next meeting, currently scheduled for Feb.7.
The U.K. central bank last reduced rates in December.
"Tighter conditions will discourage borrowing to finance spending on residential and commercial property, on business investment and consumption," King said. "In 2008, it is likely that a less buoyant housing market will go hand in hand with slower growth of consumer spending."
ECB Focused on Inflation… For Now
Many analysts are convinced the European Central Bank, which has held its lending rates at 4% since mid-2007, also will have to cut its rates as the U.S. economy stalls.
European industrial production fell in November for the second time in three months, leading some economists to assert that Europe manufacturing is already experiencing its first recession since 2001. Growth in Europe's service industries, which account for about one-third of economic output, also slowed this month to its weakest point in more than four years.
Meanwhile, a decade-long housing boom has ground to a halt, and tighter credit standards are beginning to dampen consumer spending. Morgan Stanley (MS) has already trimmed its 2007 forecast for Eurozone growth from 2% to 1.6%.
Despite this, ECB Chairman Jean Claude Trichet yesterday reiterated that inflation remains his main concern.
"Particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility," Trichet told the European Parliament in Brussels yesterday.
The rate of inflation in the Eurozone was 3.1% in December, the European Union's statistics office in Luxembourg reported. Inflation averaged 2.1% in 2007, the eighth consecutive year the measure has breached the central bank's 2% ceiling.
Food prices were the main motivation behind the rise in prices. Food-price inflation was 4.8% in December, up from 4.3% the month prior – its fastest advance in five years. Energy inflation was 9.2%.
Inflation is indeed a problem, but most analysts still believe the ECB would be better off cutting rates sooner rather than later. If it doesn't, the dollar will remain weak, paring the ability of U.S. consumers to buy European exports. That can only do further damage to the European economy, analysts say.
Still, convinced that Europe can decouple itself and withstand the fallout of a U.S. recession, the ECB is holding out for more evidence of an economic downturn in its own neighborhood. To many, the stance is a reminder of the position the central bank took after the tech bubble burst.
When the dot-com implosion forced the U.S. Fed to cut rates in January 2001, the European bank was adamant that the spillover would be limited. Ultimately, it was forced to capitulate: It slashed rates by May of that year.
David Brown, chief European Economist at Bear Stearns Cos. (BSC) in London, thinks the Bank of England will cut its rate next month and the ECB will do so in the second quarter. He told Bloomberg News that it's unlikely the banks would take such action outside their regularly scheduled meetings.
"The longer they leave it, the more they'll have to do," Brown said.
Can the Dollar Bounce Back?
If other central banks follow the Fed's lead and slash their rates, it may open the door for a greenback rebound. But unless – and until – that happens, the U.S. dollar will have to have to rely onto keep it from sinking further.
Interest rates on treasuries have plummeted as investors seek shelter from the global stock market storm. Two-year yields are at their lowest level since 2004, while yields on 10-year notes are near levels not seen since 2003.
Lower interest rates usually have an adverse effect on the dollar because they mean lower returns for those who invest in dollar-denominated assets. But with the prevailing weakness in the U.S. economy, investors are settling for investments they perceive as being safer.
"The rate differential is not that important to investors at this time. The negative impact of the slowing U.S. economy is what worries most investors. That is why money is flowing back to U.S. bonds for safety," Mark Wan, chief analyst at Hang Seng Investment Securities Ltd., told AFX News Ltd.
The dollar may suffer some more short-term value depreciations, but if the ECB and U.K. central banks ratchet back interest rates as most analysts predict, the dollar may yet rally in 2008.
News and Related Story Links:
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