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By Jennifer Yousfi
And William Patalon III
Money Morning Editors
If U.S. Federal Reserve policymakers make the expected quarter-point rate cut at the end of their meeting today (Wednesday), the impact will be felt well beyond U.S. borders.
Indeed, the interest-rate reduction could set in motion a series of diverse global events that will impact such seemingly unrelated areas as European inflation, global food prices, the U.S. dollar, American exports, and the already chilly relationship between the European Central Bank (ECB) and the government of France.
For any of this to happen, however, the Fed first has to act. Most observers believe the U.S. central bank's policymaking Federal Open Market Committee (FOMC) will reduce the Federal Funds rate for the seventh time since mid-September, dropping the benchmark borrowing cost from 2.25% to 2.0%.
According to many experts, the Fed's timing will be excellent. Economists have increasingly come to believe that the U.S. economy is probably in a recession already, although most await more-certain evidence before actually making the pronouncement.
Some of that evidence could come out today. U.S. stocks traded in a narrow range yesterday (Tuesday) as the market awaited two important announcements: The advance estimate of U.S. Gross Domestic Product (GDP) and the central bank's rate-reduction decision – both due out today.
"Another large batch of companies has reported quarterly earnings results, but overall, they have failed to move the needle that much as the market is in a wait-and-see mode ahead of the GDP data and the FOMC decision on Wednesday," Patrick O'Hare at Briefing.com Inc. told the AFP news service.
There are some strong dissenters.
"There is no reason why the Fed should be cutting rates right now," Richard Yamarone, director of economic research at Argus Research Corp., told MarketWatch.com.
What Tales GDP Doth Tell
Although GDP is a lagging indicator, analysts anxiously await the report since it will demonstrate whether the U.S. economy is as weak as many believe. According to a Reuters' poll, first quarter GDP is expected to clock in at a sluggish 0.2%, down from a 0.6% growth rate in the fourth quarter. Reuters developed the consensus estimate by averaging 89 predictions, which ranged from contraction of 0.8% to growth of 1.5%.
Most analysts, including those at UBS AG (UBS) and Lehman Brothers Holdings Inc. (LEH), felt March's surprisingly strong durable goods orders and an increase in inventories would tip the balance in favor of slim growth in the first quarter. However, analysts did note that inventory increase could signal weakness ahead, especially if not supported by the accompanying increase in sales needed to create the "sell through" that would keep additional inventories from piling up.
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"A $5 billion accumulation of [inventories] would add almost a full percentage point to GDP growth and, in our forecast, constitutes the difference between a positive and a negative result," RBS Greenwich Capital said in a note to clients.
A positive GDP estimate, however slight, could mean the U.S. economy is poised to skirt a true recession. The textbook definition of a recession is two consecutive quarters of negative GDP growth.
But the weak GDP estimate, which will be announced early this morning, could prove the justification the FOMC needs to recommend another rate reduction this afternoon.
CME Group Inc.'s (CME) Chicago Board of Trade futures are pricing in an 82% chance that the FOMC will recommend the U.S. Federal Reserve make a quarter point cut, bringing its key interest rate down to 2.0%. When the Ben S. Bernanke-led central bank started its rate-cutting campaign last year, the Fed Funds rate stood at 5.75%.
And if policymakers do order the rate-reduction, most analysts believe it will be the last one for awhile; those same CBOT futures indicate a 71% chance that the Fed will hold the line on interest rates when the committee meets again in June.
"The direction of Fed policy hangs in the balance, and there are people like me that hope the central bank quits sooner rather then later," Jack A. Ablin, chief investment officer at Harris Private Bank, told The New York Times.
But here's where the global wild cards come into play.
When Everything's Wild
With its ambitious rate-cutting strategy, the Fed has stoked domestic inflationary pressures and helped accelerate the decline of an already-sinking dollar.
Officially, the U.S. inflation rate stands at about 4%, though many experts – including Money Morning Contributing Editor Martin Hutchinson – believe the actual U.S. inflation rate is much higher. In fact, anyone who studies the sharp increases in energy, food prices, commodities, healthcare, and a university-level education may find it tough to argue that prices aren't headed higher.
Even with a bit of a rebound, of late, the dollar is down more than 7.3% against the euro in the past six months, 12.35% in the past 12 months and nearly 28% in the last 54 months. The greenback is down substantially against other key currencies, too, and that's helped fuel a massive run-up in the cost of energy and food-related imports – all highly inflationary for U.S. consumers.
At the same time, however, the cheap dollar has made U.S. exports very competitive abroad. Indeed, for foreign buyers of such big-ticket products as Boeing Co. (BA) jetliners, the plunging dollar has served as a global blue-light special. Boeing's bureaucratic arch-rival, Airbus SAS, hasn't been able to compete, and a week ago was actually forced to raise prices on two of its commercial jets – citing rising steel prices and a falling dollar as the two key causes.
On Sunday, French Economy Minister Christine Lagarde said the gap between the U.S. and Eurozone interest rates was way too large, and called for a change in interest-rate policies – either by the Fed or the European Central Bank (ECB).
The U.S. Fed has been slashing rates to jump-start economic growth while also keeping a horrid housing market from putting the entire economy to sleep. The ECB, by contrast, has kept rates high to combat inflation – even though that strategy is pushing Europe into an undesirable slowdown.
"We are in a delicate situation where we have, on the one hand, an American Federal (Reserve) which has a policy of very low rates and a European Central Bank which has maintained high interest rates," Lagarde told LCI Television and RTL Radio, the global wire service Reuters reported. "The differential in interest between the two, it seems to me, is a little too big at the moment."
Paris has long been a vocal critic of what French President Nicolas Sarkozy has termed the ECB's overly narrow focus on fighting inflation. But Sarkozy and Co. have been criticized by both Germany and the ECB for attempting to meddle in the business of a supposedly "independent" central bank.
With Eurozone inflation running at about 3.6% – its highest rate since the measure for that portion of the European market began in 1997, the European Central Bank (ECB) has left its key refinancing interest rate unchanged at 4.0%, despite some very definite signs that Eurozone growth is slowing.
The European Commission, the executive branch of the European Union, said Monday that Eurozone growth would continue to erode throughout 2008 and 2009. The EC said the combined economic growth rate for the 15 countries that use the euro would slow to 1.7% this year and 1.5% next year. The EC has cut its growth projections twice since November.
But here's perhaps the biggest wild card: Inflation will climb to 3.2% this year, more than it previously forecast and well outside the group's comfort zone of just under 2%. And it's not expected to throttle back until late next year. For that reason, the commission remains focused on inflation, which it considers "the main problem that we have to face in the short term."
According to the EC, "the recent sharp rises in food and energy prices have depressed households' purchasing power and consumer spending in the last quarter of 2007 and are expected to continue to do so during most of 2008," the commission said.
That may have to change. And here's why.
Another cut in the U.S. Fed Funds rate will cause the dollar to skid and inflation to escalate still more, giving U.S. exporters an even bigger advantage over European rivals.
Dollar-denominated commodities such as oil, metals and food will continue to escalate in price. Initially, it will appear only as if U.S. exporters are just gaining an ever-larger advantage over their counterparts in Europe. European corporate profits – and stock prices – will start to feel the squeeze.
Sarkozy and Co. will step up their lobbying efforts against the EC and ECB – pushing for the rate reductions needed to restore parity with Europe's economic rival across the Atlantic – making the French president even less popular.
In time, the EC and ECB will realize that this is not a temporary competitive disadvantage, but instead is a full-fledged slowdown. Even worse, it's not a conventional slowdown, for Europe's growth is declining steeply, even though inflation is escalating.
In short, the European economy has been afflicted with stagflation, something not seen since the 1970s in the United States.
Surprisingly, the question no longer is: What does Europe do? Instead, the first major moves will fall to the U.S. central bank, which will have to start boosting rates to draw the over-abundant liquidity from the financial markets and tame inflation.
But the process could take some time.
A Bullish View
Few mainstream economists see such a dour outcome for the Fed's rate-cutting strategy.
Right now, they note, the battered U.S. greenback is poised to post its strongest month against the euro in nearly a year on anticipation that the Fed might be ready to end its rate-slashing campaign.
"If the Fed is not at the end of the easing cycle, it's near the end," Jeff Gladstein, global head of foreign-exchange trading at AIG Financial Products (AIG) in Wilton, Conn., told Bloomberg News. "I don't think the dollar will strengthen aggressively by any stretch, but I do think it's trying to bottom."
The dollar has risen 1% against the euro in April and almost 4% against the yen during the same period.
But even those economists temper their optimism. The weak dollar is taking its toll, as commodities (many of which are dollar-denominated) continue to soar. It is likely the Federal Reserve hopes the softening U.S. economy will dampen demand and help to keep inflation in check. But if the current economic contraction does nothing to bring down soaring food and fuel prices – even if Europe doesn't fade badly – the Fed will have no choice but to reverse course and raise rates to battle inflation.
At least two Federal Reserve Bank presidents are more concerned with inflation than growth. Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, both voted against lowering rates at the last FOMC meeting.
"Really, what we're dealing with are inflationary expectations," Fisher said in an interview last week with Fox Business News,.
"And what we're trying to make sure doesn't get out of control," he said, "are the expectations of consumers and businesses, the way they price their behavior, the way they conduct their businesses, to begin imputing certain inflationary patterns, because then they'll be exacerbating inflation, and that's something certainly none of us wish to see."
[Editor's Note: Money Morning Associate Editor Jason Simpkins contributed to this article.]
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