With Seven Rate Cuts Since Fall, Could the Fed Be Exporting Stagflation to Europe?

By Jennifer Yousfi
And William Patalon III
Money Morning Editors

The U.S. Federal Reserve reduced the benchmark U.S. lending rate by a quarter point - from 2.25% to 2% - yesterday (Wednesday), and then hinted that it will take a break from one of its most-aggressive rate-cutting campaigns in decades.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity," the policymaking Federal Open Market Committee (FOMC) said in the statement announcing the interest-rate move. Central bank policymakers also said that "recent information indicates that economic activity remains weak" before going on to say "uncertainty about the inflation outlook remains high" and noted that the Fed would continue to monitor both economic growth and inflation closely.

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The Fed launched this rate-cutting campaign on Sept. 18, not long after it became clear that the U.S. subprime mortgage meltdown was having a global impact. The reason: Banks in Germany and France had - for whatever reason - invested in debt obligations that were backed by subprime mortgages. And when the subprime market blew up, so did the holdings at those foreign banks.

Before the crisis broke, and even in its early weeks, Fed Chairman Ben S. Bernanke and other U.S. leaders repeatedly maintained that the problem was limited in scope and that no real "crisis" would evolve. Today, an estimated $312 billion in write-downs and credit losses later, the central bank has slashed interest rates seven times and helped engineer the bailout of The Bear Stearns Cos. (BSC) by JPMorgan Chase & Co. (JPM).

Yesterday marked the seventh time since mid-September that the U.S. central bank reduced the Federal Funds rate, the interest rate that banks with excess reserves charge one another for overnight loans. The Fed Funds rate also serves as the benchmark for the Prime Rate, the base rate that commercial banks use to price loans to their best and most-credit-worthy customers. Wachovia Corp. (WB) and other lenders pared their Prime Rates by a similar quarter point - reaching 5% - shortly after yesterday's Fed action.

Stocks soared in early trading. But then the markets shed those gains following the announcement of the expected quarter-point cut and ended mostly flat. The blue-chip Dow Jones Industrial Average Index was down 11.81 points (-0.09%), to trade at 12,820.13. The tech-laden Nasdaq Composite Index shed 13.30 points (-0.55%), to reach 2,412.80. And the broader Standard & Poor's 500 Index decreased 5.35 points (-0.38%), to hit 1,385.59.

"The markets pretty much knew what was coming and what we wanted to see were the changes in the statement," said Joel Naroff, president and chief economist of Naroff Economic Advisors, in a note to clients. "There were some, but the Fed still left itself plenty of wriggle room to do what it pleased."
Central bank policymakers have slashed the Fed Funds rate by a total of 3.25 percentage points from its starting point of 5.25% level in mid-September, and the comments that accompanied yesterday's announcement seemed to indicate the committee was content to step back and allow rate reductions to work their way through the U.S. economy.

The committee also reduced the lesser-known Discount rate (the rate charged at the Fed's discount window) by a quarter point to 2.25%.

A Look to the Future

The committee did leave some room for future cuts by stating it "will act as needed to promote sustainable economic growth and price stability."

Some analysts took the statement as a clear signal the Fed plans to pause.

"We do not expect to see a rate cut at the next few meetings without a substantial contraction of the economy," Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, told Bloomberg News. "We are not yet to Memorial Day weekend, but the Fed effectively told us today to take the summer off."

But the language was ambiguous enough to leave the statement open to some interpretation.

Ian Shepherdson, North American economist at High Frequency Economics, sees it differently. The Fed may "intend" to stand back and take a breather, but if a series of reports show that the U.S. economy is weakening, all bets are off.

"If the data deteriorates further, as we expect, the Fed will ease again," Shepherdson said in a note to clients. "Today's statement is important - [but only] today. Tomorrow, the numbers are back in charge."

Steve Gallagher, chief economist at Societe General SA (OTC: SCGLY) in New York, called the statement a "soft non-binding pause."

Not a Unanimous Move

Two FOMC policymakers reprised their dissenting votes. Both Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, had opposed the last rate reduction. Yesterday, they were again the only voices of dissent against yesterday's rate cut, opting instead to hold rates steady.

"The two dissents show they are still worried about inflation," Diane Swonk, chief economist at Chicago-based Mesirow Financial Holdings Inc., told Bloomberg "This is a Fed ready to watch from the sidelines."

Playing to a Global Marketplace

The real question investors have now is this: What happens next?

Whatever the answer turns out to be, it's almost certain to have a global spin - and a global impact. And that answer is likely to contain two other terms: Inflation and the dollar.

In its commentary, the Fed did warn that "some indicators of inflation expectations have risen in recent months."

Indeed, many would argue that the Fed itself - with its ambitious rate-cutting campaign - has actually fueled domestic inflation and exacerbated the decline of an already weak greenback.

Here's why some analysts believe that. The central bank's preferred inflation barometer - the personal consumption expenditures price index - rose at only a 2.2% annual rate in the first quarter. But that indicator excludes food and energy prices - the most volatile and steeply climbing portion areas in the U.S. economy.

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, with yesterday's latest rate cut by central bank policymakers, anyone who has closely followed the steep-and-steady increases in energy, food prices, commodities, healthcare, and a university-level education may find it tough to argue that prices aren't headed even higher, still.

Because interest rates abroad are higher than they are in the United States, capital has moved out of the U.S. market and into the higher-yielding regions. The result: The dollar has dropped precipitously.

The fact that most central banks abroad have held rates steady even as the Fed pared U.S. rates has only exacerbated the greenback sell-off.

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 decline in the greenback has helped fuel inflation - which, in turn, has fueled the massive run-up in the cost of food- and energy-related commodities.

Take oil. Because crude oil is priced in dollars - in fact, they're referred to as "petrodollars" - a consistent drop in the value of the dollar almost automatically translates into an escalation in oil prices, since members of the Organization of the Petroleum Exporting Countries want to keep petroleum prices steady.

Crude oil hit a new record of more than $119 a barrel this week. On Sept. 18 - the day before the Fed started cutting interest rates - oil was trading at $81.52 a barrel. By the end of the year, oil prices had escalated to $96 a barrel. That means that crude-oil prices have soared 46% since the central bank started cutting interest rates.

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.

Foreign Fury

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).

While the Fed has been slashing rates to stave off a recession - largely ignoring inflationary pressures in the process - the ECB 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."

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.

Two scenarios are possible.

In one, the EC and ECB will suddenly 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 U.S. economy will have exported "stagflation" into the European economy, a syndrome not seen since the 1970s in the United States.

If that happens, the question won't be: What does Europe do? It will be: How can the U.S. central bank help us?

If the ECB slashes rates, it will boost growth. But it will also further fuel inflation.

So it's possible that 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.

In the second possible scenario, the ECB decides that the ongoing rate differential is economically unhealthy, and that stronger growth with some heightened inflation is a much better option than a no-growth malaise and a currency/interest rate climate that has left Eurozone businesses totally vulnerable to U.S. exporters.

In that case, the ECB starts to slash rates, leveling the playing field and perhaps blunting a U.S. recovery. That could force the U.S. central bank to move anew.

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