Dollar: Do-Nothing Fed Could Be Dangerous

I often speak of my “prices model.” It is a model that measures inflation in real time using various securities in the marketplace along with spreads from fixed income world. For the most part, this indicator has been very accurate in terms of the movement in the CRB over the past few years. Additionally, it has served as a drag or wind at the back of the oil market as well depending on its direction.

When the index is on the rise, commodities are doing well and there is excess demand relative to supply. Add in a dovish/easy fed, an explosive rally in assets occurs – basically what occurred in commodities from 2002 to the spring of 2006. The indicator is also a threat to the Fed as it normally forecasts what the CPI will do down the road – normally 6 to 8 months for the most part.

The dollar is influenced by this indicator in a few ways. First, if the Fed is perceived to have inflation under control and the prices index is doing much of nothing, then the dollar finds support because dollar based assets are not losing value in real terms. When the index is on the rise but the Fed is too easy, which was the case during the Greenspan era in the earlier part of this decade, then the dollar has problems.

If you add to this slowing growth and an overly tight Fed, which occurred in 2000 and 2001, the dollar takes a major dive. Conversely, in the mid 1990’s, when growth domestically exploded higher and inflation remained somewhat tame while the Fed kept its rate structure about inline with the prices index, the dollar began its major rise from the mid 80’s all the way to the 120 level in 2000. With this “model” set up, what does one make of the current environment?

The current environment is now showing declining price growth year over year. The last time this occurred was in 2003 right before the breakout in stocks. At the time the Fed was easy but the level of bearishness in stocks was so high that even with supporting factors like corporate profits and money growth, equities could not rally – so the Fed basically goosed the market with another cut.

Prior to this 2003 period, the prices index began to fall at the beginning of the breakdown in the markets in 2000. The fed stayed tight in the face of declining asset prices and predictably the economy nosedived in 2001. So in short, the mistake that Greenspan made in 2000 was not made again in 2003. Now in 2007, Big Ben and his Merry Men from the Fed are now staring at the same scenario. Do nothing and see if the markets resolve these sub prime issues or do something to stabilize things but at the same time, create easy monetary conditions.

So what does the Fed do at the moment? Take a chance that housing does not get worse and keep policy steady or give the market a “bone” and see if things stabilize. Well, the key I think stands with my Fed Funds Fair Value Model. It currently resides around the 5.12% level which indicates that the Fed is now too tight by about 13 bps. This is nothing substantial but it is a minor stress on the system. So if Big Ben wanted to give “support” to the economy at the moment, a cut may do it because it would create monetary conditions that are not too easy but easy enough to provide some help to those in sub prime and other areas of the real estate market.

So what does this have to do with the price of milk? Actually, I just wanted to throw that out there. Actually it has everything to do with the price of milk. As the move in the prices index shows, the Fed has won its battle against inflation, so the direction of prices going forward is lower. It also indicates then that there is little risk then in cutting rates at the moment because prices are tending lower. What is important for the dollar is simple; if the Fed responds with a cut sooner than later, then the greenback might get a lift as growth is expected to rise versus stable to slowing prices. If the Fed does not act and things get much worse, the dollar could get pummeled and break the pennant formation that has been in place for 2 years!

This is a very key time for the dollar. However, I would hazard to say that it is even more important now for the Fed to act because if the Fed hangs tough and does nothing, they are taking a big chance. A stable dollar contains import prices and by extension inflation. A rising dollar puts downward pressure on prices and a falling dollar puts upward pressure on prices. In short, if the Fed does nothing, they could end up with conditions that promote stagflation because the dollar will be falling. Thus, based on the evidence, I think the Fed needs to cut because now the risk is not to the upside in prices, but to the downside in growth and the potential issues a falling dollar could create.