Why the pressure is all on the FED

The fact is that the evolution of the global markets is mostly relying on the shoulders of the Federal Reserve. This is not really a good thing as any decision to be taken by the Fed will have negative consequences. It does not really have as much wiggle room as other central banks.

Take the ECB (European Central Bank) for example. Its decision is actually helped by the Fed's activity. The ECB has to balance price stability with economic growth. With Europe suffering increasing inflationary pressures at the same time as a slowdown in economic growth, the decision on whether to tighten monetary policy becomes difficult. If it lowers interest rates to boost the economy it could get a real inflation risk. Raise interest rates and the economy could take a further hit.

However, general market forces will help the ECB to make its decision as well. Although the strong euro has been strongly criticized, the fact is that it is not really hurting exports as much as economists feared. With exports sustained, the ECB does not have to greatly worry about it hurting economic growth. Why are exports sustained?, because the Euro mostly revalued against the dollar. Therefore, exports are simply moving away from the U.S. towards China and other emerging countries. On the other hand, Europeans are seeing an increasing buying power. This helps imports increase as foreign products are getting relatively cheaper. Furthermore, cheaper products help control inflation. For example, with oil priced in dollars, the high euro makes up for part of the higher oil prices.

SO, the higher euro is helping Europe fight inflation. However, the latest indicators show that inflation might be starting to increase in Europe. Therefore, increasing interest rates is not out of the question just yet.

Although economic growth is slowing down in Europe and the credit crisis is being felt, boosting the economy is not as urgent for ECB since the FED is already lowering their interest rates. After all, the credit crisis originated in the United States and more dire measures will have to be taken in that country.

In other words, the FED cutting interest rates is helping the ECB with its objectives. Lower interest rates for the dollar is helping to ease the credit crisis and will help mitigate the spill-over effects to other countries. At the same time, it drives a weaker dollar which in turns helps Europe control inflation, especially on dollar-denominated commodity prices.

U.S. inflation could head into real danger. Consumer prices have been remarkably resilient so far as it remains very close to the 2% level. However, with the Fed passing more cuts, it sets up a real inflationary risk with a steeply declining dollar.

Bernanke is speaking to Congress...

Bernanke states that the FED is anticipating moderate but positive economic growth for the following quarters...

Seems to be a fairly positive assessment of the economy. Hoping to see a bottoming out of the housing market by spring 2008

Concerns are being expressed for home owners, and desire for agencies to help homeowners keep their homes

"Market outside of housing has been remarkedly resilient."

See my review of the FOMC statement here


"For the first the trade sector has been positive to U.S economic growth." This statement was made in reference to higher U.S. exports (driven by USD weakness). See the post,

Just One Reason Why The Economy Will Remain Strong

USD drops to new lows

The USD drops to new lows on news that China will diversify its currency reserves. A Chinese official stated that it preferred stronger currencies over weaker currencies. China has a huge amount of U.S Treasury Bonds. If it starts selling them, it will add greater pressure to dollar weakness.

A great article by Kathy Lien of DailyFx explains why the EUR/USD is unstoppable and heading towards 1.50.

As explained, Australian and Sweden increased interest rates. This means that other central banks are willing to increase rates in this economic situation. Only the FED is lowering rates and this change in interest rate differentials is clearly the catalyst for USD weakness. Today's move to 1.4730 most likely reflects anticipation for a hawkish ECB. Most expect ECB to keep rates steady. However, the statement will probably favor the control of inflation. This would mean that the ECB along with other central banks will test the limits of their economies before loosening rates. The FED does not have this luxury because of the credit crisis and can not further restrict liquidity.

In a strange twist, raising interest rates might not have a strong impact on economic growth because it will help Europe offset higher crude oil prices!

Speech by Governor Frederic S. Mishkin, Financial Instability and Monetary Policy

Below are the concluding remarks of the speech...

"As I have argued here, under the mandate it has been given by the Congress, the Federal Reserve has a responsibility to take monetary policy actions to minimize the damage that financial instability can do to the economy. I hope I was clear in communicating to you that policies to achieve this goal are designed to help Main Street and not to bail out Wall Street. Pursuing such policies does help financial markets recover from episodes of financial instability, and so it can help lift asset prices. But this does not mean that market participants who have been overly optimistic about their assessment of risk don't pay a high price for their mistakes. They have, and that is exactly what should happen in a well-functioning economy--which, after all, is what the Federal Reserve is seeking to promote."

In the following paragraph, Mr. Mishkin describes the characteristics of high-risk investments like what happened with the mortgage subprimes...

"Adverse selection arises when investments that are most likely to produce an undesirable (adverse) outcome are the most likely to be financed (selected). For example, investors who intend to take on large amounts of risk are the most likely to be willing to seek out loans because they know that they are unlikely to pay them back. Moral hazard arises because a borrower has incentives to invest in high-risk projects, in which the borrower does well if the project succeeds but the lender bears most of the loss if the project fails."

It is worth mentioning that Mishkin emphasizes that the FED works to restore financial stability and is not promoting a bail out of Wall Street. It also differentiates this instability from economic risk but that the first could filter through to the latter.

This is an interesting speech and I recommend reading it.