Over the next few weeks, a lot of attention will fall on the US Federal Reserve (Fed) as it contemplates its next interest rate move. Based on current pricing in the fixed income markets, it seems some still believe deeper cuts are coming. But even after considering some recently released weaker-than-expected economic data, a rate reduction makes little sense right now.
Now, let's take a look at what's going on in the US. Earlier this week, on November 14, we learned that retail sales increased at a slower pace than expected. A lot of this makes sense given that gasoline is averaging $3 per gallon (can't buy as much because the money is going into the gas tank). But with the US dollar losing so much value, oil and everything else that gets imported into the country does not need to get more expensive. To clarify, even if oil's true price remains stable at say $100 per barrel, but the value of the US dollar decreases 5%, the market price for that same barrel increases accordingly. In other words, an inverse relationship exists between the price of oil (or any other commodity) and the US dollar (especially as it relates to the American economy).
Despite slower retail sales, unemployment remains low at 4.7% according to Commerce Department's new release on November 2. Not only that, but on October 31, the Bureau of Economic Analysis reported that people are making more money. This means people are working, they aren't losing their jobs and they aren't making less. Maybe people aren't spending in light of higher pump prices or perhaps they don't want to spend simply because, gasp, they don't like the sound of this horrific sub-prime mess. And forget about the abundant media reports about the lack of credit liquidity.
What's more is that real GDP continues to weigh in with positive numbers. And this is one of the Federal Reserve's primary goals; to maintain sustainable real GDP growth. Based on these latest readings, it seems the Fed has succeeded in sustaining growth. So, what's the catch?
Well, a short-run tradeoff exists between price stability and real GDP growth. While the recent rate reductions have clearly helped sustain GDP growth - heck, people are working, they're making more money, so in hindsight, these cuts were an ingenious move on the Fed's part… that is if you only look at sustaining real GDP growth. But the other half of equation, which is price stability, suffers.
To illustrate, consider that the rate cuts have resulted in the US dollar's devaluation. Where the Canadian dollar once fetched a 20-30% premium over its cross-border currency, the tables have now turned to the point where the US dollar sells at a discount to its neighbor's currency. Logic would suggest that Americans now spend less in Canada than they used to and that Canadians now spend more in the US. Good news for the US, not so good for Canada… and every other country with a strong relationship with the US, including the US itself.
While US goods become more affordable for the rest of the world (hence the higher exports numbers), the US pays more for the goods it imports like oil. Two options exist for the Fed in its quest to counter-act the lower value of the US dollar and maintain some form of price stability (its other goal). One is to start increasing rates to attract foreign investment. But, to do so, the Fed risks slowing the economy and putting people out of work. The other option is to let other central banks lower their rates, but this seems unlikely when other countries continue to report tremendous growth (double-digits for Australia).
Where does this leave the Fed? If it can't lower rates for fear of lowering the value of its currency and it can't raise rates for fear of killing the economy, what can it do?
Simple. The Fed can leave rates unchanged when it meets on December 11, 2007. A do-nothing decision makes perfect sense. The economy can't be that bad when it continues to add jobs and American workers continue to enjoy higher wages over the previous quarter. Sure, people aren't spending as much at Wal-Mart and other retailers, but why would anyone spend their money when there is so much coverage about credit seizing up, so much mention about home foreclosures and an impending recession? In these times, people typically start saving, a difficult chore even without higher prices that Americans face each time they stop at the gas station on their way to work.
Where the true problem lies right now is with the value of the US dollar. While the Fed cannot raise its fed funds rate without far-reaching consequences, it can leave the rate alone and start seeing gradual improvements to the currency value. The perception worldwide will be that any problems in the US have been contained and that a so-called economic reversal is imminent. Will people lose their homes if rates don't continue to drop? It's possible even in a low-rate environment because when people aren't working, they can't pay their mortgage anyway. And “working” isn't an issue here, not when unemployment ranks in at 4.7% or when the country continues to add jobs.
In summary, retail sales haven't grown as aggressively as economists expected. People aren't spending, but they are paying more for imported goods like oil and other commodities. The same people enjoy more competitive wages. Bottom line, the Fed has done a great job sustaining real GDP growth, but doing so has resulted in price level in-stability. Now, it faces the task of improving the value of its currency and it seems evident that to succeed in this effort, rates will not change on December 11.
