Much is being made about what the Fed will announce Tuesday about short-term interest rates. Some would contend this may be the Fed’s most critical decision in years, at least during Fed Chairman Ben Bernanke’s tenure. Here seem to be the choices, in order of what analysts seem to think is most likely:
Reduce the Fed funds rate by 25 basis points – the markets appear to have that expectation built in after the decline in the job situation and the housing/credit/hedge fund turbulence of recent months. This modest first step, the first Fed rate reduction in more than four years, probably would not shake the U.S. dollar status too much, but would it be enough to stimulate the economy and head off a recession or a stock market setback?
Reduce the Fed funds rate by 50 basis points – this would be a sharp turnaround in the Fed’s fight against inflation but could deal a real blow to the dollar as the interest rate differential with currencies such as the euro would widen, would send funds flowing overseas and would reduce confidence worldwide in the dollar as a reserve currency. The U.S. Dollar Index (which is not the same as the value of the dollar but a good proxy for forex traders) is barely hanging above all-time lows just above 78, and if that level gives way, it could set up a collapse that feeds upon itself. And that has potentially ominous ramifications for a lot of commodity prices. Besides, can the Fed really prevent a recession or does it just tag along with actions after the fact?
Keep the Fed funds rate as it is – while that might be the most supportive choice for the dollar, the disappointment for the economy, some commodities and the stock market might set off an unwelcome chain of events. Stock indexes have moved up nicely after the July-August skid, but history shows it often takes only a spark to set off a contagion. And, at this point, a non-move would seem to be the surprise that could cause a setback and make this another September-October for financial traders to remember.
I’m not a Fed governor, thank goodness, and not much good at figuring out the effect of all these fundamental factors. I’ll see what happens on the charts, but my guess is the Fed won’t take any extreme actions, won’t please either side and will muddle in the middle with a 25-point increase, leaving the dollar and the economy to work out their own situations.
Going into the Fed meeting, the key point now is that, if it comes down to guessing about the outcome of some development or the other, it is not a good time for any trader to be over-committed. Be careful out there this week!